Pretty scary. But if you’re worried about someone monkeying with your money, don’t be. The unhyperventilated truth is that funds are still one of the safest investments you can make. The reason: no other form of investment has so many safeguards against fraud built in by law, enforced by regulators and reinforced by competition. “Taken as a whole, the industry has not had systemic problems,” says Barry Barbash, director of investment management at the Securities and Exchange Commission.
That’s not to say all is perfect in fundland. But while there are isolated problems, there’s no cause for handwringing. Here are the headline-grabbing charges – and the facts behind them:
Don’t believe it. Fund companies are scrutinized by the SEC, the National Association of Securities Dealers, state regulators and independent auditors. The sheer volume and specificity of rules put out by these taskmasters would make your head spin. Yes, the SEC does need more examiners to keep up with a burgeoning number of funds. But SEC inspectors have visited the 100 largest fund families as well as every single money-market fund each year since 1991. These aren’t perfunctory appearances. Examiners comb through trading records, correspondence, internal control systems and minutes of directors’ meetings, among other things. They care about the mind-numbing details. In seven out of 10 cases the commission sends out a “deficiency letter,” which may ask the fund to alter a detail in the way it records data on stock purchases or the wording of its prospectus.
The commission is also quicker to adapt than critics like to admit. More than two years ago it noticed that new forms of exotic securities known as derivatives were creeping into fund portfolios. The rest of the world didn’t pay attention to them until earlier this year, when a number of funds suffered sharp losses from these tricky investments. Investors could have saved themselves some heartache. As a result of the SEC’s early handiwork, nearly all of the funds that sustained casualties had publicly detailed their derivative holdings.
This complaint is nothing more than a sophisticated way to whine about losing money. Fund losses in derivatives proved that a lot of fund managers didn’t have a clue about how these securities would work amid rising interest rates. That may be dumb, but it’s not against the law. When many of those same funds were earning unusually high returns thanks to derivatives in 1992 and 1993, no one complained. Piper Jaffray Institutional Government Income Fund, which had a big derivatives loss this year, gained almost 16 percent last year – while the average short-term government-bond fund returned 5.6 percent. And not every derivative devotee got slammed. For example, Monica Wieboldt, manager of Dreyfus Intermediate Municipal Bond, made good money with derivatives through the end of 1993. Then she adroitly cut her risk by hedging her position in derivatives. Her fund escaped this spring’s bloodbath.
Yeah, what about the Kemper fund manager who allegedly steered his most profitable futures transactions into an employee profit-sharing account? Or John Kaweske, the Invesco fund manager who was fired for failing to disclose stock trades in his personal account. For all the publicity they’ve received, they’re unusual cases. “The fact of the matter is, thus far there are hardly any demonstrated cases of abuse,” says Richard Phillips, a securities attorney with Kirkpatrick & Lockhart in Washington, D.C.
The numbers will surprise you. The SEC took serious action in a mutual-fund matter fewer than 10 times a year between 1990 and 1992. Last year there were 10 so-called enforcement actions, one of which barred Patsy Ostrander, a former fund manager for Fidelity Investments, from working in the investment business. Hardly a crime wave, considering that there are nearly 5,000 funds. But such drastic actions reflect earlier problems. What’s happening today? If corruption were rampant, it would likely show up among smaller, newer fund companies – the focus of this year’s SEC inspections. But both Barbash and Gohlke say they’re unearthing mainly technical oversights: a fund company that forgets to increase the size of its insurance coverage as its assets under management grow, for example. “Fund managers don’t want to rip off investors,” says Gene Gohlke, who manages the SEC’s inspection staff.
It’s not just the cops that are keeping fund companies honest. Both the SEC and the NASD get some of their best tips from fund companies ratting on their competitors. Exhaustive press coverage helps, too. Investors have zero information on the kinds of investments often used in ripoff schemes, such as oil and gas partnerships or cellular-phone franchises. But data on mutual funds is everywhere. “With this massive regurgitation of detail about funds, it becomes very difficult to do something criminal based purely on hype and puffery,” says Scott Stapf, an adviser to the North American Securities Administrators Association.
It’s not impossible to be a bad guy in the fund industry, of course. There will undoubtedly be more of them. But the criminals to fear aren’t fund managers who line their pockets by trading the same stocks their fund does. They can be easily rousted. It’s the sham artists who operate outside the bounds of normal industry practices who will be difficult to catch. Consider First Investors, a company charged by Massachusetts and New York state securities officials in 1990. According to regulators, it used aggressive telemarketing techniques for more than five years to sell risky junk-bond funds to novice investors, telling them that the funds were as safe as certificates of deposit. “First Investors proved that you can use all those nasty techniques associated with boiler-room operations in the mutual-fund industry,” says Stapf. “There’s no reason why someone couldn’t come along and do that again.”
That’s why state regulators are devoting most of their time and budgets to investigating the ways companies hawk funds – and why investors should be vigilant about handing their money to operators who promise outsize returns. But there’s no need to give up on the industry as a whole. Villains and skulduggery just aren’t that plentiful in the fund industry. It’s a fact that may not generate heart-racing headlines, but it should improve your slumber.
