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Here's why: The bulk of small, independent fund companies have a three-person board, chaired by the fund company's founder. The manager-chairman typically takes no pay for service on the board. But to get a super-majority of independent directors and install the new chairman, governance costs are going to double. First, you have the salary of the new director. Assuming the new director gets paid the same as the two existing ones, that's a 50 percent increase in the money needed to pay directors. (Of course, the fund manager could step off the board and leave just two directors but that changes the dynamics of how the board works.) Next, factor in extra pay for the chairman's duties and add the legal counsel that the independent directors will hire as part of other regulatory changes. Throw in the need to hire a compliance officer -- a high-priced outside lawyer for most small firms -- and you'll see a tiny fund's expense ratio rising by 0.25 percentage point. Even a fund with $200 million in assets will be looking at its expense ratio taking a hit in the neighborhood of 0.02 percentage point. Those are small points, but serious dollars. Fund managers who built their firms from the ground up -- such as John Montgomery of Bridgeway, Mario Gabelli of the Gabelli Funds, and Ron Muhlenkamp of the Muhlenkamp Fund -- say they couldn't necessarily start their fund firms today, or survive corporate infancy if they did. More on Reforms Side Effect Chucke Jaffe, Boston Globe 6-06 Depending on who is doing the accounting, the scandals that were uncovered last fall cost investors under $1 billion, most of which will be covered by restitution by the companies. The cost of making compliance and disclosure changes is estimated to be more than $1 billion when spread across the fund industry. And some of these expenditures will be ongoing, meaning that the cost of the cure is certain to eventually outstrip the disease that required this medicine in the first place. More Side Effects Brooke Masters, Washington Post 6-12 The Securities Industry Association, which represents brokers, has heaped scorn on a plan to provide customers with a personalized point-of-sale disclosure about the fees and commissions they would pay on a particular fund. The SIA wrote in a comment letter that there was "no logical justification" and that the SEC's plan would cost $2.7 billion a year, substantially more than the industry's annual profits from mutual fund sales each year.
California Atty. Gen. Bill Lockyer this year launched an intensive investigation of sales practices at Capital Group, Franklin and Pimco. Lockyer is looking broadly at the issue of "pay to play," or payments fund companies gave brokers to tout their products [a practice also known as 'revenue-sharing']. The Securities and Exchange Commission also is focusing significant resources on pay-to-play investigations, say people familiar with the probes. The upcoming legal action against the industry may be more likely to strike a nerve with average investors, because it may call into question why a broker or other financial advisor sold them a particular fund. State and federal regulators are expected to try to show that many fund companies have had special sales arrangements with brokerages that weren't fully or properly disclosed to investors. Those arrangements had the potential to cause brokers to sell clients funds that weren't necessarily in the investors' best interest, fund industry critics say. Instead, some brokers may simply have favored the funds that provided the biggest kickbacks to their firms. The SEC has reached one settlement in a revenue-sharing case with Massachusetts Financial. It agreed to pay $50 million to settle allegations that management didn't tell its fund trustees or investors enough about sales deals it had with brokerages. On the brokerage side, the SEC in November reached a $50-million settlement with Morgan Stanley over allegations that the firm didn't properly disclose to investors the sales incentives it received to push certain funds. New rule-making on disclosure of pay-to-play arrangements is a virtual certainty. The SEC already has proposed a number of rule changes, and the NASD, the brokerage industry's self-regulatory group formerly known as the National Assn. of Securities Dealers, last month said it would form a task group to suggest additional changes in fund sales practices and disclosure.
Rather than watch these folks sweat, let's pitch -- or barge -- in. Imagine you just took the helm of a fund firm fresh off a shaming scandal settlement with regulators. There are a number of steps you could take to right the ship. So, here are a handful of changes that might go a long way toward putting the focus back on customers. Rethink Incentives: Portfolio Managers and Fund Directors Recent pay studies show that a fund manager's hefty bonus comprises the majority of his or her take home pay and is often driven more by the health of firm's sales and profits than by the returns delivered to fund holders. This positions a portfolio manager to benefit from letting his or her fund get as big and expensive as possible -- hardly paving the way for good returns. It would make a lot more sense to let a manager's performance set a bonus instead of a benchmark or peer comparison over the past three years. As for fund directors, their pay has steadily risen in recent years, but public filings indicate that about 15% don't own a single share of any of the funds they oversee. It's hard to imagine directors would take their job representing shareholders less seriously if half their pay came in the form of fund shares they had to hold for at least three years. If You Pay to Play, Reach Into Your Own Pocket One of the many questionable fund-firm practices that surfaced in recent years is so-called "shelf space" or "revenue sharing" deals. In these agreements, many funds have directed portfolio trades to certain brokerage firms in return for giving the firm's funds heavy promotion to Main Street investors. Regulators are currently examining these agreements at several firms, including Edward D. Jones., and whether they lead brokers to pitch mediocre funds. While questionable, these arrangements are common and not illegal if disclosed to investors in fund filings. They're also not necessarily surprising given the glut of mutual funds that investors and advisers have to choose from. The SEC has proposed rules that would require a broker to disclose such incentives when selling a given fund. What to do? If you have to make these payments to stay in business, do the right thing and pay them with your own money, not brokerage commissions.What to do? If you have to make these payments to stay in business, do the right thing and pay them with your own money, not brokerage commissions. Sell What You Make, Not What Sells Did the number of stock funds more than triple in the 1990s to nearly 4,000 because the population of savvy stock-pickers exploded? Sadly, no. In the throes of a bull market, many firms took an "if you launch it, money will come" approach to running their business. In many cases, mutual-fund firms went from sober money managers to firms run by marketers to gather assets during the bull-market boom.
To get closure on the case, Putnam will pay $110 million, split evenly between the SEC and Massachusetts regulators. Of that amount, $10 million is earmarked for shareholder restitution; the SEC's $50 million will go to helping shareholders, while the Massachusetts money goes into the state's general fund. Therein lies at least part of the rub. Here are some key questions raised by the settlement: Why isn't Massachusetts giving all of its money to shareholders, and how will the SEC deal with its cash? The key to the settlement is the amount of the damages. Regulators were prepared to argue that the number was huge, but settled for a middle ground. The likely figure on shareholder losses directly attributable to Putnam allowing improper trades is $9.5 million. If the final number goes above $10 million, regulators will turn more of the ''fine" part of the punishment into the ''restitution" part. In Massachusetts, the law states that any money beyond restitution must go to the state's general fund, where presumably some of it pays the cost of current and future securities litigation. The SEC, meanwhile, is under enormous political pressure to return everything possible to shareholders; how it allocates the penalty money will become an ongoing saga. The important thing to remember with both agencies is that investors in the funds will get back everything regulators believe they lost. They are being made whole. Investors should not expect regulators to make them a profit. And fund companies should not expect that they can return the money and walk away happy. There must be a penalty, and in this case it amounts to 10 times the loss, plus the repayment of those lost dollars. If investors don't get back more than they lost to improper trading, what have they gained? Investors who want more can jump in on the many class-action suits filed against the firms identified as having troublesome trading deals. The Putnam settlement didn't create a profit for investors, but it did the next best thing when it comes to those civil cases: It included an admission of guilt. The standard regulatory settlement that a fund firm agrees to amounts to ''We didn't do it, but we won't do it again." But Putnam admitted the facts of the Massachusetts case, and while this was done 'solely for the purposes of resolution of this administrative proceeding,' everyone watching agrees that the admission makes the job of the plaintiffs' attorneys a whole lot easier. Investors also gain, in general, from the improvements made by funds as a result of these regulatory cases. Would cutting fees have been a more appropriate punishment? Regulators are split on this issue. The SEC won't make funds cut fees, while New York attorney general Eliot Spitzer has made fee cuts a big part of his strategy. Fee cuts effectively deliver savings back to shareholders. They don't help investors who have bailed out on a troubled fund, but they are extremely efficient at making sure that shareholders get direct benefit from the penalties. That being the case, especially given how some investors are reacting to Massachusetts keeping penalty money, fee cuts might make investors like future settlements more than this one. Why haven't other states jumped in to get similar settlements? In some securities cases, state regulators pile on after settlement, going after money for their state or investors. In this case, it appears they recognize that all shareholders will be made whole, and they are not going to muddy a process that most see as working. While some people in the fund business are saying settlement deals like Putnam's are not fair to the firms, they should remember that fund companies operating in all 50 states might have had to settle in all 50 states. There was talk that the damages could be calculated in a way to make them much bigger. Why didn't regulators push for that much larger damages calculation? Because there was a strong potential they would have lost. If the liabilities had been determined to be a lot smaller -- which was something the fund companies have been maintaining -- it would have put big-dollar settlements on the endangered species list, and there are a few big fund companies that have yet to settle anything. By settling now, regulators helped to ensure that investors in those fund companies are likely to be made whole, too.
The firms touched by the scandal have been at the forefront of changing policies and improving rules to help eliminate trouble spots. While they should not be praised excessively for taking these steps -- some of them got dragged into doing it -- neither should anyone discount the value behind these better practices. The firms that have not been tagged by charges, for the most part, certainly are not making any big pronouncements that they are stepping up to meet the highest new industry standards. Consider Pioneer Investments, one of the dozens of firms subpoenaed by regulators over rapid-trading allegations. In most of these cases, the central issue has been that fund management allowed special customers to move in and out of funds without facing restrictions and fees that applied to ordinary individuals. People close to the case/investigation into Pioneer say regulators found evidence that there had been special trading arrangements. But Pioneer had a strong case that its actions were legal, even though similar actions landed other firms in the soup. Pioneer prospectus from last year includes a heavy dose of 'you can't engage in market-timing in this fund' language, but it also contains a clause that says the restrictions do not apply to 'accounts that have a written exchange agreement with the distributor.' Who would have such an agreement? Hedge funds, big institutions, and 'special' customers. Investors need to keep a close eye on how their fund firms are changing thier rules. Many fund companies - particularly those embroiled in the scandal - are clearing up their disclosure policies now, but are leaving loopholes that protect them in the event of unforeseen or undetected trading problems. In Pioneer's case, new prospectuses are being drawn up that strike the language about written exchange agreements. But with the language buried deep in the prospectus, investors aren't likely to notice the change. So here's the logical solution to this disclosure problem. Whenever a fund firm changes its prospectus language, it should note those alterations upfront, in a special section placed ahead of the key financial information. In the end, the only way for the entire fund industry to emerge from these scandals in better shape is for each of its participants -- and not just the ones who have been charged with something -- to prove that they are putting an end to the shenanigans.
Some index funds also use use soft dollars to buy research they seemingly do not need. "Section 28e [the provision of law that spells out permissible uses of soft dollars] permits using research from one fund to benefit another," observed Richard Marshall, partner at Kirkpatrick & Lockhart.
New York Attorney General Eliot Spitzer said improper trading at MFS, the nation's 11th-largest fund company, cost investors $175 million. Under the settlement, that amount would be returned to customers as restitution, and MFS will pay a $50 million additional fine. MFS, under a separate agreement with the New Hampshire Securities Bureau, will pay an additional $1 million for investor-education efforts. The fee cut, part Mr. Spitzer's settlement, amounts to $25 million annually over five years, or 5.9%. That's smaller than the 20% cut at Alliance, according to Mr. Spitzer's office. But Alliance had fees among the highest in the industry, whereas MFS fees are close to industry averages. Just the Facts Fund Performance Only 18% of actively managed large-cap funds outperformed the Standard & Poor's 500 index. Only 17% of actively managed large-cap funds have out-performed the S&P 500 over the past 10 years, according to industry monitor Morningstar. And even that number could be afflicted with survivorship bias. (Meg Richards, AP 2-22) Home Page Factoids Update Top Sites
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