Several of the nation's largest brokerage houses have been accused of misconduct in
mutual fund trading practices. More than 95 million Americans, and half of all the
nation's households, own shares of mutual funds, making them the main investment
and savings vehicle for the middle class. But that did not stop investors.
While some tarnished funds lost investors, 2003 was spectacular for the mutual fund
industry, as investors funneled the highest amount of money into equity funds in more than three
Washington Post staff writer Brooke Masters answers questions regarding the probe on mutual funds and what it means to investors.
Editor's Note: Washingtonpost.com moderators retain editorial control over Live Online discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions.
What is the status of the mutual fund probe? And what should we expect next?
Brooke Masters: Federal, New York, California and Massachusetts regulators all have open probes into alleged malfeasance by fund companies and the brokers who sell them.
Two big fund companies--Putnam and Alliance--have reached settlements with the Securities and Exchange Commission in which they agreed to pay penalties for allowing insiders or big customers to engage in short-term trading that hurt their regular customers. Alliance paid $600 million in restitution to customers and promised to cut future fees by $350 million over five years. Putnam has hired an outsider to determine how much it should pay.
At least half a dozen other big fund companies are also in talks with regulators about similar allegations, including Invesco, MFS, Janus and Strong.
Now the SEC and NY Attorney General Eliot L. Spitzer are looking at how the traders financed their trades, known as "market timing" and a couple of big banks (Bank of America and others) may face trouble for that.
Brokers too are under scrutiny for failing to tell their customers they were getting paid to push specific mutual funds
Has the mutual fund scandal had any affect on the performance of funds? Where can I find what funds have been implicated in this growing scandal?
washingtonpost.com: Q4 Mutual Fund Report
Brooke Masters: Individual funds have been hurt by the timing, according to regulators--particularly small cap and international funds--and some academics suggest that overall losses may have topped $5 billion. But unless you had a boatload of money in a particular international fund, you probably didn't suffer large losses personally
Mt. Lebanon Pa.:
Since the settlement with Spitzer (New York Attorney General) and the SEC amounted to a smoke and joke so far as punishment went, is there any likelihood that the civil suits will sink real teeth in the backsides of the "evildoers", to borrow from the president? Until real justice is served up, mutual funds are for chumps.
Thanks much. HLB
For latest news visit our Probe on Mutual Funds Special Report.
Brooke Masters: I think that's not quite fair. Alliance is paying $250 mill in restitution, which is probably more than investors actually lost.
It is true that none of the big shots have gone to jail, though.
The problem with civil suits in this arena is that actual dollar losses from timing are not that big--a couple hundred dollars per account, in most cases. It was more of a broken trust issue.
The probe on mutual funds means to small investors is very little. I worked for a large securities firm for 15 years on Wall Street. If there's one thing that was drilled into us, it was watch out for your largest investors, even if it's at the expense of the smaller investor. We go through these 'scandals' on a regular cycle. A few politicians and prosecutors get their names in the newspaper, a few high profile investors go to jail, changes are made to the laws, and then the securities firms figure out how to work around the new laws. It's difficult to comprehend how greedy people on Wall Street can be, it's even more difficult to try to banish it through legislation.
Brooke Masters: There does seem to be a cycle of bad behavior followed by prosecutions and promises of reform. Even Spitzer says he expects his investigation will only result in a temporary clean-up. ("the temptations are too great" he said the other day)
I guess the best one can hope for is that the bad guys will have to come up with a new way of doing business and that investors are given enough information that they can do a better job of spotting the more obvious scams.
What do you recommend investors do to protect themselves? The prospectus that mutual funds send out to investors are so arcane. I don't think the average person, including myself, understands exactly how much I am being charged. Is there any book or website that you can recommend to me?
Brooke Masters: The most important thing you can do is to figure out how much you are paying in fees. High fees clobber your returns. The SEC has an investor calculator that allows you to plug the numbers from your prospectus and the amount of money you have into their online form. Then it tells you how much you would pay in fees. You can even plug in the numbers from two different competing funds and compare them.
What is "market timing"?
Brooke Masters: Market timing is the short-term trading that's at the heart of the scandal. Basically it exploits the fact that mutual funds set their prices once a day but stock prices move all the time.
Here's an example: The ABC Japan Fund sets its price at 4 pm every day based on the closing prices in the Japan market (which actually were set 14 hours earlier). On Monday, the US market shoots up 5 percent. Since international markets usually follow the US market, the smart money says that the Japan market will shoot up on Tuesday. So you buy 1000 shares of the Japan fund at 3 pm on Monday and get the Monday price of $10. On Tuesday the Japan market does shoot up and you put in an order to sell at 3 pm. When the price is set at $12 you just made $2000.
It's a totally legal strategy for the buyer. What's illegal is for the fund company to tell mom and pop that they can't do it and then cut secret deals that allow rich people or hedge funds to do it. It's also illegal if you have secret information about what's in the fund (which was the problem with insiders doing market timing at Putnam)
Mt. Lebanon, Pa.:
Does your reply to my question indicate that you think the SEC are not Federal DoNothings? Perhaps you'll share with us some trenchant news of them pulling the skin of Wall Street malfeasors?
Thanks much. HLB
Brooke Masters: Many investors believe the SEC lost sight of the ball in the go-go 1990s and the early part of the crash. The regulators seem to be honestly trying to go after the bad guys now. The question is whether the penalties they exact are what society wants.
How big should the financial penalties be? Should they put the fund companies out of business?
If you want the bad guys to go to jail, that's the Justice Department's job (or Spitzer's). The feds have yet to bring a criminal case based on the fund scandal and so far Sptizer has not charged any top level fund folks with criminal malfeasance
Are investigators looking at funds that perform poorly? I can't believe some can lose more than 20 percent in a quarter when others are gaining that amount.
Brooke Masters: Investigators are looking at funds that did especially poorly when there appears to be a reason for that other than sheer bad stock picking. (some funds' returns were depressed by the timing, for example). But it's not a crime to guess wrong about when the high-tech boom was going to end.
Is it true that Spitzer and other regulators are planning to look into the fees that funds charge investors?
Brooke Masters: Spitzer has already forced Alliance to promise to cut fees by an estimated $350 million over the next five years, and the SEC is looking at whether some funds are misusing something called a 12b-1 marketing fee. There are also SEC proposals in the works to make sure investors get information about fees that are easier to understand so that they can comparison shop and pick funds that charge less.
How much have the mutual fund and corporate scandals hurt the U.S. economy? Do you think that it's impacted the inflow of foreign investments in U.S. companies and sent that money overseas instead? What impact will this have 10 years from now, when globalization hastens this phenomenon?
Brooke Masters: I think it is really unclear. A falling stock market tends to depress consumer spending, but that was mitigated by the home refinancing boom.
I'm not the right person to be doing 10 year forecasts (if I could do that I'd be a lot richer than I am now)
What non-governmental groups grade mutual funds? Where can I go for more independent research?
Brooke Masters: Morningstar and Lipper both do ratings based on returns.
There's also a rather funny website called FundAlarm.com that professes to tell investors when their funds are such dogs that they should jump ship.
One thing to be wary of, past returns are not always good predictors of the future and funds that are four star funds one year may be overpriced and not do all that well the next year.
High fees however, always cut into returns and they don't change much from year to year, so if you are comparing two funds that seem otherwise similar, seriously consider going for the lower fees.
Why is Spitzer spearheading this? Are there any plans to bring criminal charges against any of the fund managers? After all, don't they have a fiduciary duty to work in the best interest of the investor?
Brooke Masters: Spitzer has an impressive ability to spot holes in existing regulation. People all over the securities industry knew that some investment banking research was suspect, but he jumped all over it and started releasing e-mails that proved his point.
Similarly, he says he has been concerned for years about the way mutual funds are run, so when a tipster came to him with great information about illegal after-hours trading, he jumped on it.
Also, success begets success, so some tipsters now call Spitzer because they think he'll jump on their information
Has the mutual fund industry come forward with any collective statements about the fund probes, best practices, etc.?
Brooke Masters: The industry trade group the Investment Company Institute (ICI) has come out with some basic recommendations (mandatory redemption fees for short term trades, tighter controls on when trades can be placed)
They've got a website ici.org but remember they represent the industry
Are you aware of any problems among European or Asian-based funds -- i.e. problems similar to the ones you reported on?
Brooke Masters: The European stock regulators have asked their fund companies for information about market timing deals. I don't think we know the results yet.
When the markets dropped after the 1990s boom, there was great concern that investors would stop putting so much money into mutual funds and individual stocks. That didn't happen in 2001 or 2002. But with the media reports of questionable mutual funds practices, did that change in 2003?
Brooke Masters: Not at all. The market was booming and the money poured in. Individual fund companies saw withdrawals (especially Putnam and Strong, where there have been allegations of insiders doing the market timing), but overall investors have stuck with the industry.
How do mutual funds plan to reimburse investors for the millions lost because of special trading privileges given to hedge funds?
Brooke Masters: Most fund companies say they have hired outside experts to calculate the losses to investors and they will use the information to make restitution to the accounts that were harmed. Critics and class-action lawyers are skeptical that these experts will feel pressure to minimize the losses and some plaintiff's attorneys plan to hire their own experts.
Do you recommend getting out of fund families that have been implicated in this scandal? Will the big companies survive the redemptions? Thanks!;
Brooke Masters: So far, all the big fund companies are hanging tough--Alliance even saw assets under management increase in December.
It's a tough call as to what investors should do.
Getting out of a fund may have personal financial implications (capital gains taxes, or a back-end load--industry speak for the fee you pay when you sell Class B shares) that you should consider carefully.
Silver Spring, Md.:
Are mutual funds regulated differently from regular stocks?
Brooke Masters: Yes. They are regulated by the SEC's division of Investment management under the 1940 Investment company act.
Their boards hire a fund company to run the fund and negotiate the fees investors pay.
I've been impressed by John Bogle who founded Vanguard Funds. It seems that more fund families would do well to follow that company's practices of being straightforward with the fees charged and even more importantly, keeping them low. Are there other fund families who, in your opinion, match Vanguard's reputation?
Brooke Masters: Vanguard has always made low fees its competitive advantage. It is also a mutually owned company so it doesn't have company shareholders who expect to make profits.
There are other companies with low fees (check Morningstar or FundExpenses.com for information)
There are also other good companies that have so far been untarnished by the scandal and produce good results for their customers. Some investment professionals believe it may be worthwhile for investors to pay somewhat higher fees if they like the overall returns.
I say if a couple of these thieves were publicly hung that might send a message. Instead of the normal slap on the wrist.
Brooke Masters: That's a question for a death penalty expert!
Do you believe the industry is improving as a result of putting the industry under a microscope?
Brooke Masters: The industry is certainly being a lot more responsive to investor concerns and the SEC is certainly looking at it a lot harder and trying to propose rules that will help investors.
As an investor, how do I know that the fees that I'm paying are in fact being used to manage the fund/market the fund? Are there any questions that I should be asking? And who would I ask if I don't use a broker?
Brooke Masters: Marketing fees have to be listed separately as 12b-1 fees, as opposed to management or administrative fees. It should be right in the front of the prospectus or on the website.
The SEC is also supposed to be proposing new rules for telling customers about marketing fees at tomorrow's meeting, and you can read about it in my article that will be in your Post tomorrow morning (shameless plug).
Hoping this question is applicable to this discussion.
I'm 27 and would like to open a Roth IRA which most would recommend at my age to invest in large index stock funds. Now many companies like Vanguard and Fidelity claim they never charge loads on their index funds, but with this scandal, it has me nervous since I am a novice at this whole investment thing.
What is your opinion on index funds and are they falling victim to these scandals too?
Brooke Masters: Not all index funds are equal.
In addition to loads (the fee charged for buying into the fund) you need to look at ongoing management/marketing/administrative fees (again in the prospectus). They can be as low as 0.20 percent or as high as 2 percent. That makes a difference to overall returns.
Also index funds do what the market does. Statistics say the market historically does go up over the long haul But there can be periods when it goes down or just bounces around. Make sure you can live with that, if you chose an index fund.
I'm interested in investing in mutual funds, but I don't want to invest in any of the funds under investigation now. What fund families are currently subject to probes?
Brooke Masters: There are more than two dozen firms that have been implicated and probably more to come. Best thing to do is to check a fund company's website and see what it has to say about market timing.
Brooke Masters: I've got to run off to an SEC briefing about--you guessed it--mutual funds.
Thanks everyone for your time.