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Get Four
|  | NOVEMBER 5, 2003
If You Really Want Fund Reform... A trio of prominent -- and outspoken -- shareholder advocates take on the subject of how to fix the scandal-plagued industry In the wake of market-timing and late-trading scandals, the mutual-fund industry is emerging as far more corrupt and conflicted than anyone believed it to be. Luckily, the fund business also has a crop of feisty shareholder advocates who are full of ideas for how the industry can get back on the straight and narrow. BusinessWeek Department Editor Lauren Young interviewed several of them: Jack Bogle, founder of Vanguard Group; Don Phillips, president of Chicago fund tracker Morningstar; and Gary Gensler, former Treasury Undersecretary and author of The Great Mutual Fund Trap. Their suggestions for reform are wide-ranging: Bogle favors disclosure about compensation and stronger regulation. He argues that the funds' transaction window should be closed at 2:30 p.m. Eastern time, instead of the current 4 p.m. Phillips is looking into the possibility of Morningstar reporting fund redemption rates. Gensler, who sees fund governance as "broken," is calling for rules that ensure the independence of fund directors. Following are edited excerpts from Young's separate conversations with Bogle, Phillips, and Gensler: On how fund companies are dealing with scandal: Bogle: The boilerplate letters fund companies are sending to investors don't suggest any mea culpa at all. They say that the people that did it aren't here anymore. That's pretty weak tea. I don't think it's a good idea for fund companies to try to trivialize this. It's a crime -- a crime. It speaks very badly about the character of the management. This has become a business not of stewardship but of salesmanship. Phillips: The fund industry has been so widely respected that this is new territory. To senior fund execs, talking with the public meant accepting accolades. At first, a lot of people were in denial. Many senior executives were trying to compartmentalize this, [but no one can do that] today. Many groups are doing their own internal investigations, and they're a lot better off if they take control of this. Then they may be able to control the restitution, as opposed to having [New York Attorney General] Eliot Spitzer do it for them. They still don't have any road map out of here, but at least they acknowledge they're in a mess. My biggest frustration is the deaf ear that the industry turned to Jack Bogle. Bless Jack Bogle for having the courage to speak out for what's right. On new regulation: Bogle: Everybody is so hooked on marketing in this business that nobody has the guts to wait until the next day to execute a trade. Now we have to wait for the Securities & Exchange Commission to make a ruling about cut-off times. We need much more disclosure of fund compensation. [Studies show] the average portfolio manager makes $302,000. Don't make me laugh. I can tell you about a half dozen who are making $5 million per year. Putnam and Janus are the highest payers. That all ought to be disclosed. It's like the [former New York Stock Exchange Chairman Richard] Grasso thing -- when the spotlight shines on salary, things change. Plus, funds should have a mandatory 2% redemption fee for shares held less than 30 days. We don't need traders in funds. Even if it's not disorderly, it still costs money. Gensler: Fund governance is broken. We need new rules and regulations that better articulate the responsibilities of fund directors and ensure their independence. We need to have truly independent nominating policies. With market-timing, it may be appropriate to have fair-value pricing [where fund companies adjust prices to reflect events that occurred after trading in a particular stock closed]. Most certainly, they should have a rule that you cannot take an order after 4 p.m. That seems like an easy fix. Firms also need dedicated compliance officers to make sure they're really compliant with the law. On fund redemption rates: Bogle: Everybody knew where heavy fund trading was going on. If anybody had taken the trouble to look at Alger funds, they would have seen $2.3 billion of assets and $9.3 billion of liquidations. That's there for everybody to see. It's all in the annual report. Where was the press? Where was the Investment Company Institute (ICI)? Where was the SEC? These things are filed at the SEC. Nobody looked at redemption rates as far as I can tell. Alger had a redemption rate of 425%. Bank of America had a redemption rate of 300%, I think. It would be great if Morningstar would report the redemption rate. Phillips: I knew that [the redemption rate] was available in fund-shareholder reports, but before last week it never occurred to me what kind of use it would have for investors, or why it would be an interesting number to know. I'm going to look into including it. On the SEC: Gensler: I don't have much hope for the SEC. For example, in the case of Putnam, the SEC was told there were problems back in March by an employee, and they didn't act on the tip. Bogle: The SEC is under-resourced, under-prioritized. I think it needs to do an economic study looking at the compensation of fund managers and executives. It should include a profit/loss analysis of where all the money goes -- marketing, advertising, and administration. Phillips: I'm not sure exactly what the SEC is doing. Frankly, the SEC was a little embarrassed by Spitzer's findings -- it didn't make the SEC look good. It does seem like now they're knuckling down and trying to show they're on the case. On fund directors: Gensler: The directors are failing miserably at their fiduciary duty. If they were state pension directors, they wouldn't think twice about retaining different management companies. At Nations Funds, they are largely sitting on their hands, waiting for Bank of America to correct Bank of America's problems. Putnam directors are waiting for Putnam to correct Putnam's problems. I think the fund directors aren't doing their jobs. There's confusion in the minds of fund directors themselves. Who do they owe their duty to? Do they owe their duty to management companies who feed them everything, sought them out, and recruited them for these jobs? Or do they have a duty and loyalty to investors in mutual funds? It's a confusing place to be. Phillips: That's the biggest problem. Fund directors are out of sight and out of mind. Most fund investors don't even know whose job it is to represent their interests to management. There's no mechanism to hear from shareholders. Morningstar recommended to the ICI that fund literature include information on fund directors and how to contact them. Of course Matt [Matthew Fink, ICI president] and the ICI people pooh-poohed that. On the ICI: Phillips: Matt Fink said he considered himself the caretaker of the industry's reputation. The ICI believes its own press clippings. What they've done, in my opinion, is to defend the weakest practice of members.... They've lost track of what kept the industry such a clean place. Bogle: I pointed out when testifying before Congress earlier this year that the number of fund-management fees has gone up 90 times. It went from $72 million to $80 billion -- that's 90 times. The [ICI] was offended by that. They said I should do ratios. They thought it was a cheap shot. That's pathetic. On penalties for fund executives: Phillips: Some of these people need to lose their jobs and maybe even face prison time, to remind people that it's all for the investors. On the positive side of the scandal: Bogle: The great thing about this scandal is that when you get a spotlight shining on a single area of abuse, it also illuminates other areas of abuse. The managers' interests are not aligned with shareholders' interests. Phillips: The industry is very much in a reactionary mode. The big question is: Can they come out of this and charter a path to restore investor confidence? One positive is that a lot of very senior people in the fund industry now realize they need to do that. They didn't consider serious improvements before. Gensler: What this set of scandals reminds us is that fund companies work for their shareholders rather than investors. What they should be doing is providing a better product at a lower cost.  With Amey Stone in New York Edited by Patricia O'Connell
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