TCS Daily


The Mutual Fund Scandals -- One Year Later

By John E. Tamny - September 21, 2004 12:00 AM

Hidden on page C15 of last Monday's Wall Street Journal was a retrospective of sorts on the mutual fund scandals. One year after obscure terms such as "market timing" and "late trading" exploded into the public conscience, it appears that the regulatory and legal response to the supposed "scandals" has made the small investor worse off in terms of cost, choice, and competition for assets.

September marks the one-year anniversary of the mutual fund scandals. It was just a year ago that Eliot Spitzer, New York's publicity-starved attorney general, announced a $40mm settlement with Canary Capital for allegedly executing timed and late trades with willing mutual funds.

The settlement was just the beginning. With the financial media's full attention, Spitzer raged against the "cesspool" that was the mutual fund industry, it being a "morass of conflicts of interest" that failed to "aggressively keep fees (for the small investor) down."

In subsequent Senate testimony, Spitzer spoke of how "mutual fund directors and managers breached their fiduciary responsibilities" to the small shareholder, and that he would "continue to speak up for investors when necessary." Presumably fearful of seeming ineffectual, SEC Chairman William Donaldson jumped on the Spitzer bandwagon in proclaiming the scandals "damning," while vowing to "punish the perpetrators" for any wrongdoing.

Competing for headlines, Spitzer and Donaldson proved to be potent forces in the name of the small investor. In the past year the two have squeezed fines out of certain fund companies, all the while forcing new rules of governance on the mutual fund industry.

The results? Many, including this writer, predicted more than once that the supposed scandal "cures" would be make the small investor far worse off than the allegedly scandalous behavior itself. We have evidence now, but first it's worthwhile to list some of the objections about Spitzer et. al. that were made in the midst of the market-timing controversies, including my own objections.

Henry Manne, dean emeritus of George Mason University's law school, noted in a January 8 Wall Street Journal editorial that to the extent mutual funds were able to boost dollars under management with market timers, they would have to compensate their long-term shareholders "by charging them little or no load or redemption fee." Manne correctly understood that with 11,000 different mutual funds competing for extremely portable investor dollars, there was no realistic way that mutual funds could be acting in ways inimical to the small investor.

In his own Senate testimony, TCS host James K. Glassman showed a chart of fund redemptions: the mutual fund firms that allowed market timers had seen substantial withdrawals of cash from their funds; the implicit point being that Eliot Spitzer and the SEC should find a new issue. The markets had done their work for them. Regulations on top of market justice would be paid for by the investors themselves.

As an occasional TCS contributor, I pointed out in various editorials that the new rules and regulations for mutual funds would lead to reduced competition for investor dollars, higher fees, and less choice for the small investor. In "Small Investors Beware" (2/10/04), about the regulatory and legal solutions to the scandals I wrote that the process would "reduce the myriad fund options presently available to the small investor."

My July 1 piece ("William Donaldson: Eliot Spitzer Redux?") noted that the pending sale of mutual fund firm Strong was just the tip of the iceberg. More sales were "certainly on the horizon," and investors could "expect funds sharing similar styles to be dissolved into others amidst these state-induced consolidations, with retail investors once again the losers given the shrinking number of asset managers competing for their assets."

Returning to the evidence, it's in and the new investment landscape does not bode well so far for the small investor in the ways predicted above.

One rule requires all funds to have compliance officers in place by October 5th. While regulators and politicians are most often shielded from esoteric concepts like cost, companies in the real world aren't. The August 8 Wall Street Journal reported that to pay for their compliance officers, the Hennsler Equity Fund and Flaherty & Crumrine Preferred Income Opportunity Fund will pass those costs onto their investors with higher fees. So much for Eliot Spitzer's assertions about bringing costs down for the small investor.

Mutual funds will charge the higher fees assuming they're able to stay in business. The "retrospective" on page C15 ("New Rules Protect Investors, But They Can Be a Burden; Cost of a Compliance Cop") of Monday's Wall Street Journal noted, "Scandal fallout is forcing a number of small mutual-fund companies to think about leaving (my emphasis) the business." The Journal's Arden Dale went on to write that small mutual fund firms "are edging to the brink as a deadline looms for complying with investor-protection rules set by the Securities and Exchange Commission."

For those funds not being driven out of business, there are a host of others looking to exit the retail side of the business altogether according to Financial Research Corp. president, Neal Bathon. Woops! There goes investor choice.

All, however, is not lost. Apparently Bathon "has heard from a slew of firms looking for advice on possible merger partners." Perhaps not unexpectedly, the mutual fund industry will consolidate. This is not in itself a bad thing, but it should be remembered that consolidation is not resulting from normal market forces, but due to smaller funds no longer having the resources to compete amid new rules and regulations. It will be harder than ever for new and innovative managers to enter into the mutual fund industry at all. The very competition cited by Professor Manne as cost containing will no longer exist.

A research paper by Stanford Professor Eric Zitewitz provided the academic ammunition for Eliot Spitzer's initial shakedown of mutual fund firms. Interestingly enough, his report ("Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds") explicitly acknowledges that there is no direct way to calculate dilution of long-term investor assets from market timing and late trading.

While future retrospectives might prove more favorable, so far the machinations of Eliot Spitzer and the SEC (based on weak evidence) have destroyed companies and careers, all the while creating an environment that is at least for now less favorable to the small investor. In short, Spitzer has built up enormous political capital for himself, despite bringing substantial harm to an industry that he himself once acknowledged provides investment options that are "the single best vehicle for small investors."

The above in mind, and with Eliot Spitzer nakedly eyeing higher office, it's probably worthwhile for the Wall Street Journal to move stories about the aftermath of the mutual fund scandals to its front page. Bringing this story to light will ideally save New Yorkers from a Governor Spitzer, and all Americans from an Attorney General Spitzer in a Kerry or Clinton administration.

The author is a TCS contributor.


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