Every few days, new cases of fraud pop up in the $7 trillion mutual-fund industry. Big names are involved, and funds that seemed pristine. The charges center on something you probably didn’t know was possible: skimming profits from your mutual fund that ought to belong to you.
Turns out, dozens of fund groups secretly created two classes of investors–you (on the bottom) and clever big-money players (on top) who get a better deal. These favored traders buy fund shares at “stale prices,” meaning prices that are a few hours old and lower than they should be. When the insiders sell at the higher, current price, they collect a rigged profit, which comes out of your pocket. Your individual loss is small; nevertheless, it’s theft.
Half of the largest 88 mutual-fund groups allow favored traders to skim, according to the Securities and Exchange Commission–even from funds in 401(k)s and variable annuities. At Putnam, at least two managers skimmed their own funds. Fund owner Richard Strong (of the Strong Funds) skimmed his investors, too, as did Gary Pilgrim, head of the PBHG funds.
Some skimming is legal but unethical, some is flat-out against the law. Fund companies have allowed both in return for fees that made their rich managers richer yet.
How could this happen to an investment that seemed so well regulated? Simple. No one bothered to see if the funds really followed the rules.
Well, some people bothered. Half the fund groups do an honest job. In the other half, however, the “compliance” officer (if there was one) had nothing to do but play Minesweeper–and maybe send a few fruitless memos up the line. (“Dear Mr. Strong, Sir, puhleeeze stop, if you don’t mind.”)
The SEC could have bothered. It knew all about the stale-pricing game and, in fact, had already advised funds to use “fair value pricing.” That calculation wipes out stale prices and gives the bad guys nothing to cheat with. About a dozen large funds agreed. But then the SEC dropped the ball. It was shocked, shocked, to learn how widespread abusive skimming is today.
Finally, the funds’ own boards of directors should have bothered, but they probably hadn’t a clue what was going on. What’s more, they’re toothless. I know of only two cases where boards challenged fund management–in the Yacktman Funds (1998) and the Navellier Funds (1997). Both times the directors lost and the funds sued them personally. They won their own lawsuits but had to pay their legal fees. The message to directors: sit down, shut up and collect your big paychecks (average: $113,000 at the 50 largest funds).
“Only around 40 percent of mutual-fund groups have independent board chairs,” says Gavin Daly, editor of BoardIQ, a publication for fund directors. In the other 60 percent, they’re affiliated with management. But let’s face it: even the “independents” kowtow to the boss.
Illegal or unfair trading isn’t hard for directors to spot, says New York Attorney General Eliot Spitzer, who brought the first of these scandals to light. They just have to compare their funds’ total sales with total redemptions. When the two are about the same, skimming might be going on. I asked Lipper, a fund-tracking service, to list the larger funds where redemptions reached 90 to 110 percent of sales. It found 229, some looking obviously churned.
Rep. Richard Baker (Louisiana Republican) has been holding hearings on his proposed Mutual Funds Integrity and Fee Transparency Act. If passed, it should put the funds on a straighter path–requiring, among other things, better audits, compliance officers and disclosure of all fees and expenses (you often pay more than you think). But to pass it, voters have to get really mad–and maybe they will, as Spitzer nails more bad boys (last week, Schwab and U.S. Trust).
Mercer Bullard, head of Fund Democracy, an advocacy group, likes the Baker bill but wants more. “The underlying problem is that people in high positions are willing to break the rules,” he says. He dreams of a Mutual Fund Oversight Board, empowered to spot-check compliance and breathe down directors’ necks.
What should you do right now? If convenient, consider selling the fingered funds. Other investors are bailing out, which generates costs and maybe taxable gains for those who stay. You can’t lose all your money in a fund as you might with an individual stock. Your fund won’t go bankrupt. But it might perform poorly.
I’m still a believer in mutual funds–especially low-cost funds, because they have your interests at heart. Choose managers with long tenures who invest their own money along with you. Some suggested fund groups: American, Davis, Dodge & Cox, Fidelity, Longleaf, TIAA-CREF, T. Rowe Price and Vanguard. If they get in trouble I’ll eat this page. (Gulp.)
