The Mutual Fund Industry: A Mountain of Abuses

If you thought the investment research scandal during the tech bubble was the only corrupt corner of Wall Street, think again. Either through investment plans at work or through funds purchased directly, most individuals now own portfolios of mutual funds much as people owned stock portfolios decades ago. Mutual funds are a very big business and that always invites opportunity for chicanery. Some years ago when former Governor Eliot Spitzer was still Attorney General of New York, he uncovered widespread abuses in the mutual fund industry that the SEC had just ignored. What first seemed to be a molehill had turned into a mountain of abuses.

Mutual Fund Sales Fees and Garnering “Shelf Space”
If you go to the grocery to buy cleanser, you know that the only difference between Ajax and Comet is the company that produces it. Either will effectively scrub your sink clean. To best attract your attention while shopping, the manufacturer pays for “shelf space”, putting the product closer to your eye level and not on the bottom shelf, by co-op advertising monies or product discounts. The mutual fund industry is now so overcrowded with thousands of mutual funds that it must do the same thing to get its product promoted to the ultimate buyer. When you ask your account executive for fund recommendations, remember his goal is to sell you the fund that will put the biggest commission in his pocket. In mid-November, this set of problems was moved to center stage when Morgan Stanley paid a $50 million fine for promoting its own funds and those of other fund groups who paid them large brokerage commissions for “shelf space.” Often brokers sell funds that have huge penalties for early withdrawals or that have large upfront sales fees, neither of which are particularly good for the investor. Ask before you commit. Those commissions are deducted from the account before your money even has a chance to go to work for you in the fund. Rest assured that every other brokerage firm does the same thing.

Allocating Performance within a Fund Family
In the late 1990’s era of hot IPO’s (Initial Public Offerings) one of the easiest ways to successfully launch a new mutual fund, was to pump it full of IPO’s. Because the largest fund families are their largest brokerage customers, when the investment banking firms allocate the shares in IPO’s to the public, it’s no shock that the fund groups get the largest allocations. If an enormous multi-billion dollar mutual fund receives 100,000 shares of a deal that goes from 20 to 50 its first day trading, its nice but the impact of that gain is insignificant. On the other hand, if the same 100,000 shares is stuffed into a relatively small $100 million fund within that same fund family, the contribution to performance becomes very significant. A $30 gain on 100,000 shares = $3 million or a 3% boost to the smaller fund’s value and performance. At the time, The New York Times highlighted a study undertaken at Insead and Essec, two leading European business schools, showing that the 50 largest fund families seemed to favor those funds within their groups that either needed a boost to be number 1 in its investment category or that charged higher fees than the group overall when handing out those IPO allocations.

The Flap About Late Trading
When Spitzer swooped in to investigate this industry, lots of folks lost their jobs. The jobs lost at the top of the mutual fund industry circled around the practice of entering orders to buy or sell a fund late in the day, after the markets are considered to have closed. The daily value of a mutual fund is determined at the close of business(generally at 4 p.m. Eastern time).  Orders are supposed to be placed prior to the close when the final value for the day is still unknown. Some fund groups restrict in and out trading once they can identify hedge funds or individuals who follow that pattern. Traders of funds are disruptive to effective portfolio management of those funds. The fund manager either has to maintain a large cash balance or be subject to having to liquidate holdings on a moments notice to meet redemptions. If markets are still open in other countries or stocks are trading on Instinet in the after market, it is possible for the traders to discern if the fund is likely to rise or fall in value the following day. More importantly, the in-and-out folks are basically scalping the fund for a few pennies in value in either direction and thereby shortchanging the regular investors who buy and hold the fund.

The Bad News About Taxes on Mutual Funds
Taxes on mutual fund investments were a big issue in the late 1990’s when funds were enjoying strong gains. Mutual funds have a “tax declaration” or record date after which fund holders are “stuck” with any realized gains on the portfolio even if they weren’t invested in the fund during the period of the gains. Savvy investors know to liquidate the funds before that tax due date so that somebody else pays those taxes. From 2000-2002 most mutual funds were losing money so the issue faded in the memories of most shareholders. The same thing happened in 2007-2008 but then the sharp rally after March 2009 caused a change in this scenario. Pay attention to this in years of big stock market gains. Otherwise, you can buy a fund shortly before the tax date for its year end and be stuck with large taxable gains that belong rightfully to somebody else who owned the shares in the period when the fund was rising but sold them in time so they didn't have to pay the taxes.

Fund Fees Include “Their” Marketing Expenses
Years ago, in SEC Rule 12B5, mutual funds were allowed to bill their existing customers for advertising and other marketing expenses to get new fund participants. According to recent numbers in the Wall Street Journal, the average fund fee is 1.47%. Some funds charge much higher fees.

The Alternative to Funds; Your Own Registered Investment Advisor
Perhaps you have grown tired of being an anonymous number at a mutual fund company? The biggest advantage to hiring your own investment advisor, if your assets are large enough for that to be an option, is that you can actually speak with the individual who is managing your money. You can look forward to a personal relationship with your Advisor. That puts you in the driver’s seat so that your investment goals and objectives are crystal clear and your investments are selected accordingly. You can also better control your taxes.

On balance, you will pay no more in fees. Pick a firm whose fee structure is lined up exactly with your own interests. Our firm, Gramercy Capital,  charges a management fee based on the assets under our management. If your account goes up, our fees go up. If your account declines in value so do our fees, so we do best when your account rises in value. That means our interests are perfectly aligned with yours.