In 2003 the nation’s 95 million mutual fund investors, as well as pension plan sponsors and other consumers of money management services, began learning of the pervasiveness of illegal and unethical behavior in the money management industry. Twenty years after the mutual fund boom began, fueled by 401(k), IRA, 403(b), 457 and other legislation, the masses got their first glimpse of the myriad games money managers have been playing with their money. It is not surprising that the first generation of Americans to hire professional money managers en masse should eventually learn that there is a dark side to this industry. Investors have been disappointed with the results their professional managers have delivered over the years and have grown tired of perpetually chasing, yet somehow never obtaining, the stellar returns advertised by funds.
In 2003 investors discovered they were not solely to blame for the poor investment results they have experienced. Investors gained insight into how the industry has been skimming money from their accounts. And every day brings new revelations that the game has been rigged.
While the financial press has attempted to downplay the magnitude of the harm to the nation’s investors, it is staggering and longstanding.
Our analysis has concluded that well over 50% of the billions in mutual fund investment advisory fees retail investors have been paying are excessive. Mutual fund boards have failed to fulfill their fiduciary duties related to negotiating fees with managers. Poor performing managers are virtually never terminated. By the way, the pricing of institutional investment advisory services is also irrational and often excessive. Participants in defined benefits plans are also being fleeced.
Mutual fund brokerage commission rates related to portfolio trading are twice what they should be and portfolios are “churned” to create commissions to compensate brokers selling fund shares. The brokerage commissions paid by pensions are also excessive, often inflated due to undisclosed institutional marketing arrangements.
In addition to widespread use of client commission dollars for retail and institutional marketing, the common practice (permitted by the SEC) of managers’ using “soft dollar” commissions to purchase investment related research they would otherwise have to pay for themselves is being re-examined. If managers are already being paid an advisory fee, why should they be permitted to dip into client funds to pay for research they use in connection with managing client portfolios—even if the research may benefit clients? “Soft-dollaring,” a hidden charge that costs investors billions, is prohibited by many astute pensions; few retail investors understand this arcane practice or appreciate what it costs them. Mutual fund boards have failed to curtail use of “soft dollars” by managers, enriching managers beyond the hefty advisory fees mutual funds pay.
Illegal personal trading by mutual fund portfolio managers, traders and other senior investment personnel costs investors billions. Since a felony conviction may result in a manager being statutorily barred from managing a mutual fund under the Investment Company Act, the federal statute that regulates mutual funds, certain fund complexes have engaged in fraudulent document creation and destruction to conceal illegalities. If convicted of criminal wrongdoing, these fund companies could be out of business.
Time and again the interests of mutual fund investors have been compromised by advisers seeking to further their own objectives. Mutual funds have been treated as “retail sucker pools of money” far less fee and performance sensitive than separately managed accounts. The marketing strategy of many fund companies has been to retain assets by keeping brokers who sell fund shares to investors fat and happy, as opposed to doing what’s best for investors. “Assets under management” has come to mean “assets used by management” as the mutual fund industry has lost any ethical moorings it may have once had.
The staggering harm mentioned above has been longstanding. While the financial press would have the public believe that the transgressions surfacing at this time were desperate measures adopted by the mutual fund industry as assets under management plummeted around 2000, illegal and unethical activity has been pervasive for over 20 years. Thus, the true cost to investors, compounded over the years, is in the trillions. The effect upon the nation’s retirement savers is tragic. For example, we have encountered 403(b) participants that are paying investment advisory fees in excess of 3% to invest in mutual funds. How much of the investment return accumulated in an individual’s retirement account over a lifetime is eaten away by such excessive fees? It is as if these investors were throwing money into a bank account that pays no interest and is subject to equity risk. These people appear doomed to join the ranks of the impoverished elderly.
Skimming by the mutual fund industry is a significant factor in explaining why the nation’s retirement savers enter into retirement with lesser assets than they envisioned—far less than necessary to support a quality retirement lifestyle.
Eliot Spitzer is almost solely responsible for the education of the masses regarding money management abuses that began in 2003 and will continue well into the future as investigations progress. The SEC, NASD, NYSE, FBI, state securities regulators and an inept judiciary all are responsible for the current deplorable state of the money management industry. The SEC has utterly lost its reputation as an effective regulator, as it seems determined to undermine or prematurely settle any investigation Spitzer initiates. The public is rightfully skeptical of any government agency that purports to protect investors by requiring disclosures to the agency but rarely to investors themselves. The dealings of the NASD and NYSE have exposed the insurmountable conflicts of interest inherent in self- regulation. The FBI is searching for a crime it can effectively combat. Most state securities regulators are still standing on the sidelines scratching their heads wondering if they should have relinquished so much turf to the SEC and NASD over the years but afraid to take action. And after years of upholding confidentiality agreements of fund companies that conceal illegal activity in sealed court filings, instead punishing those who would cooperate with law enforcement, the judiciary’s inability to recognize investment management criminality is apparent. Thankfully, the court of public opinion is proving it is stronger than the legal strategies employed by guilty money managers.
For consumers of money management services, 2003 was one hell of a year. Here’s hoping that going forward we all become better informed investors, less prone to be victims of financial foul play. Happy Holidays!
Setting Standards For The Investment Management Industry
