Wednesday, April 21, 2004

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Why aren't mutual fund investors freaked out?

The Chicago Tribune reports a puzzling finding regarding investors attitudes towards mutual funds in the wake of scandals involving late trading and market timing:

While mutual fund trading scandals have captured the attention of regulators, investors remain relatively unconcerned, according to a study released Tuesday by a Chicago-based consulting firm.

In a survey of 402 mutual fund investors by the Spectrem Group, less than half said they were at all concerned about allegations of improper trading in the mutual fund industry. A little more than 20 percent said they were "very concerned."

Just over one-third of investors said they were "concerned" or "very concerned" about late trading and market timing, the two practices that have spawned the scandal roiling the $7.6 trillion mutual fund industry. Meanwhile, nearly 1 in 5 investors said that as long as they earned a high rate of return on their investments, they didn't care about claims of favoritism for big investors.

"There's an overall lack of knowledge on the allegations," said Ann Mahrdt, a director at the Spectrem Group, and one reason for the lack of concern is "they don't see it affecting their bottom lines."

In fact, nearly 60 percent of investors said they were concerned about fee disclosures, compared with 37 percent for market timing or late trading.

For the record, I haven't been following the scandals/investigations involving mutual funds, even though all of my stock investments are in such funds. Mostly that's because these funds haven't tanked -- and even if there was a downturn, I try not to get too exercised about fluctuations in the short-term.

Those who have more information about this scandal should comment away -- I'm hoping that this is one of those episodes in which the system actually worked, and these abuses were caught before they could dramatically affect market integrity.

[You're just an assistant professor -- maybe people with real money do care about this?--ed. Not according to the Trib piece:

The wealthiest investors--those with incomes of over $100,000--display significantly less concern over improper trading allegations, and are less likely to demand action, such as seeking reimbursements from improper trading or participating in class action lawsuits against fund companies.

You can take a look at Spectrem's press release about the survey by clicking here.]

posted by Dan on 04.21.04 at 01:03 PM


Why I don't worry about my mutual funds.

Shareholder-owned mutual fund company

posted by: ch2 on 04.21.04 at 01:03 PM [permalink]

For me, it's because I know the more money I make, the more they make. Specifically, 12b-1 fees definitely go up as I make more money.

However, many investors are worried. Many funds (putnam) had huge outflows when investigations made big news.

posted by: ericinTX on 04.21.04 at 01:03 PM [permalink]

Ditto what Ercin TX posted: my financial advisors sold their considerable stake (in which I had a miniscule share) in Putnam.

posted by: Bruce Cleaver on 04.21.04 at 01:03 PM [permalink]

I think the lack of outrage/fear can be attributed to a couple of factors:

1) I think you hit it right on the head - when mutual funds are doing well, people tend to not care so much. Most funds, and the market in general have picked up tremendously since the SEC and Mr. Spitzer started their investigations (I think fall of last year?).

2) It seems to me that most people see the market-timing and late trading scandals as one-off type problems that only bother less then stellar mutual fund company. I think the problem is much more fundamental then "a few bad eggs". Buffet has some meaningful commentary regarding the shenanigans at most mutual fund companies:

3) The mutual fund companies in general, unlike Enron and what not, have been very, very quick to defend or settle. They have a very strong vested interest in painting a very moral and upstanding picture of themselves to the general public, after all, that's where your retirement is going.

posted by: Jason on 04.21.04 at 01:03 PM [permalink]

First of all, one of the biggest scandals has to do with market timing which IS NOT ILLEGAL. The "mutual fund scandal" has mostly to do with Elliot Spitzer's desire for the NY Governorship. He will do anything to attempt to show that he is siding with "the little guy" over the big and powerful investor's. Unfortunately, like so amny things the government does, the measures aimed at "cleaning up" the mutual fund industry will do far more harm than good. The more regulations and fines imposed by the government, the less profitable and worthwhile it will be for brokers like me to advise smaller clients. Hence, the clients who need or help the most are the ones who will suffer the most.

posted by: Paolo on 04.21.04 at 01:03 PM [permalink]

Paolo, market timing is not illegal, specifically. However, mutual funds are required by the Securities Exchange Act to act in a fiscally responsible manner - for the good of their shareholders. Therefore, market timing, if it affects the value of the funds CAN be illegal.

Moreover, late trading is specifically illegal under the same act. Once the markets close, the mutual fund cannot allow trading of their funds for that trade date. This is also what many fund companies, including Bank of America and Putnam, have been accused of.

Additionally, the SEC, chaired by a Bush appointee (Donaldson) and the MA atty. general are also looking into these alligations and pursuing companies that violate these rules. Spitzer isn't alone.

Finally, regardless of Spitzer's ambitions, he has an obligtion to uphold the law, which in the securities business, is generally designed to protect investors.

posted by: EricinTX on 04.21.04 at 01:03 PM [permalink]

besides your sad dig at a tremendously courageous and honest man (Spitzer), you are not telling the entire truth about market timing's legality.

While market timing may not be illegal per se, claiming that you will not allow it but then allow it for some, constitutes FRAUD. And THAT, is ILLEGAL.

posted by: ch2 on 04.21.04 at 01:03 PM [permalink]

EDIT: I meant to say the Investment Company Act, not the Securities Exchange Act.

Also, good point about the fraud ch2.

posted by: EricinTX on 04.21.04 at 01:03 PM [permalink]


I want to correct one statement you make. The market timing activity is not per se illegal, but but they are a violation of the policies of the mutual funds themselves. Since the funds have disclosed these policies in their public filings over the years, a systemic failure to uphold these policies is an SEC violation.

posted by: Appalled Moderate on 04.21.04 at 01:03 PM [permalink]

The mutual fund "scandals" are basically scams that skim a bit of money out of the fund through market-timing shenannigans (which may or may not be legal) and after hours sales (which definitely are).

As a percentage of the total fund assets, the losses due to this skimming is what, a quarter of a percent? (this is a barely-educated guess - anybody got a better number?) Compared to the 5% upfront sales load or the 2% annual expense ratio or the 12b-1 marketing fees, it's pretty much small potatoes. They're already legally skimming a couple of percent as it is, who's going to be outraged by a little more shrinkage?

Which isn't to say that I like it, it's just hard to get exercised over it.

What does piss me off about the mutual fund companies is their irresponsible hands-off approach to corporate governance. They stand by and watch as profits are squandered on overblown CEO compensation. They stand by and watch as phony numbers are floated by crooked accountants. They stand by and watch as "auditors" rubber-stamp the fradulent balance sheets. Hey! Those are our profits that are being diverted to crooks! The funds should have enough clout at the shareholders meetings to do something about it.

posted by: uh_clem on 04.21.04 at 01:03 PM [permalink]

Among other things, if people have been making money in mutual funds and now discover that X has been going on all along, they generally discount X on the grounds that it was part of their calculations anyway.

posted by: Crank on 04.21.04 at 01:03 PM [permalink]

The most interesting and important point being made about the Funds is that none of the people involved in the Fraud seem to be going to JAIL.

The same thing seems to be happening in Tyco and other companies. Why is This. What is the Mesaage that is being sent to other high up office personel? Board of directors etc. What is the message being sent to other countries, 2nd, 3rd, world countries.

Two subjects that I am interested in are, Economics and politics. In my business I talked to all types and nationalities of people EVERY day about these subjects. About 90 percent of those people are not interested in eather subject and only parrot what they hear from the libral media. They quot that as fact (libral media opinion)and refuse to accept other facts a facts. So, with this in mind, it is easy to understand why people still do business with funds that are under criminal investigation. It is also understandable why the -government- will not take the hard stance and prosecute those fraudulent people.

If "THE PEOPLE" don't care, why should the elected oficials care.

posted by: Jim coomes on 04.21.04 at 01:03 PM [permalink]

There is another factor at work here - insurance. Every mutual fund company in the country is insured. Although it isn't a requirement, it is de facto the case. So, there is virtually no chance of losing your investment at a major firm even if it goes bankrupt.

Of course, Mancur Olson would have something to say about the nominal losses due to late-day trading. But that's just skimming that the individual investor would not notice.

posted by: adam on 04.21.04 at 01:03 PM [permalink]

uh clem -- Putnam estimated $10MM damages from market timing and SEC did not dispute it. That's a pittance in relation to the fund size.

I've been in the mutual fund business for over 15 yrs., and here's what Spitzer and the SEC have missed:
1. Conflicts of interest -- fund sponsor management owning interests in fund vendors (custodian banks, consulting firms, brokerages, investment bankers, transfer agents)
2. "Independent" trustees making $200K for ten or so meetings a year. Nice work if you can get it. I'll give you six guesses who nominates these trustees. Take another six guesses to tell what happens to trustees who ask too many difficult questions.
3. Loading expenses onto the funds' books instead of the management company's P&L. I've been present when a savings of $2.7MM per year to the funds was rejected because it would cost the managment company $0.4MM to implement.
4. Economies of scale simply do not happen on the expense side. On the performance side, the larger a fund gets, the closer it approximates an unmanaged index -- before expenses, of course.
Don't get me started on finding alpha or AIMR numbers published anywhere, or outsized cash positions in funds, or style drift, or "flavor of the month" sector funds...

posted by: Mitch on 04.21.04 at 01:03 PM [permalink]

Look Dan,

The reason why deregulation doesn't work is that in the real world, caveat emptor simply doesn't work. For whatever reason, the average person is simply not in tune sufficiently to cutting edge facts to protect themselves. The general public has been pounded on mercilessly for the last 15 years that mutual funds are the safest things out there to protect your investment.

Guess what, once you've invested such a huge industry wide and media wide effort in shifting the views of the center you've got a certain information-lag or cultural inertia going on. This is what let the mutual fund abuses occur in the first place. The bottom feeders realized that the average person really would just sit there and let them steal them blind.

Arguments for market efficiency, the power of the free market to correct imbalances like this, are so much academic puffery when compared to the simple facts of the real world. Oh sure, the market will correct this problem. Right after the next Great Financial Debacle needing a public bailout. It was so for savings&loans. So it shall be for mutual funds. Because the truth is that the market is composed of people, and the average person just isn't that rational, and the market ends up picking up systematic biases that prevent it from being rational as well.

Daniel Drezner meet the real world. Real world, you're already acquianted with Dan here. He just didn't pay attention the first few times ya two met.

posted by: Oldman on 04.21.04 at 01:03 PM [permalink]

The question was - why aren't investor's more freaked-out?

Answer - reported returns (or losses) are accurate. The above criticisms are valid, but if the fund reported gains of 10%, that's exactly what the investors got. The recent scandals are not in the same universe as an Enron or Worldcom, which involved massive lying which caused enormouslosses to investors.

Look, if you owned a decent equity fund, you made at least 10% over the last 10 years - it's hard for anyone to think that's a bad result for the investor.

posted by: Chris Gabel on 04.21.04 at 01:03 PM [permalink]

Investors aren't freaked because:

1. Their personal cost is tiny.
2. They have nowhere else to go.
3. They think the regulators will handle it (whether they actually will or not).
4. They don't get freaked about govt abuses which are far worse.

An earlier poster raised the S & L mess. Most Americans didn't "freak" then and it was far, far worse (because it was due to stupid govt policy).

posted by: stan on 04.21.04 at 01:03 PM [permalink]

Speaking for myself, I don't care so much cuz I swear by index funds, which have really low expense ratios and turnover. Mostly Vanguard's Wilshire 5000 index ETF (VTI), so I don't have to worry so much about everybody jumping on a stock before it's added to the S&P 500. Plus ETFs don't price once a day and don't need to sell stocks to handle redemptions, which I think makes them immune to most of the market timing shenanigans (I could be mistaken -- and there's probably something going on in the arbitrage).

Due to commissions, I tend to invest a bit less often than your typical dollar-cost averager (about quarterly instead of monthly), but since I carry less cash than most investors (relying on my untapped credit as my emergency cash), I figure that cancels out.

The one place I care about mutual funds is my 401(k), but I have a lot more in my Roth, and our plan offers crappy funds anyway, so the scandal is the least of my concerns.

posted by: fling93 on 04.21.04 at 01:03 PM [permalink]

Why aren't people more freaked out? The more you know about the financial markets, the more you are invested, the more you know that absolutely everyone involved is as corrupt as can be. Everyone involved (especially investors) WANTS the outsize gains provided by corruption/unethical behavior and is comfortable with the way it is, because they think that even if they are down for this round of violations, in the next round they might come out ahead.

posted by: hoof in mouth on 04.21.04 at 01:03 PM [permalink]

The reality is that we are just a few years away from the massive collapse of multitudes of retirement portfolios and then you will see the public concern rear it's massive and ugly head. The rich administrators of these mutual fund invested retirement programs are riding on a wave that will collapse eventually but they figure to get off before the crash.

Better save every extra dime now, you are going to need it for your own retirement. The bad guys already have their security in place.

posted by: John C. on 04.21.04 at 01:03 PM [permalink]

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