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Untainted fund companies win as rivals 'fess up
As investors see more of the seamy side of mutual funds, those with low costs and few warts should profit, including T. Rowe Price and Franklin Resources.
By Michael Brush
If youve been astounded by wrongdoing at mutual funds so far, hang on, because theres much more to come.
Ever since New York Attorney General Eliot Spitzer fired his opening shots at the industry in September, mutual funds have been scurrying to hire white-collar criminal lawyers to root out misdeeds on their own. Theyre hoping that if they 'fess up before Spitzer uncovers their misdeeds, theyll leave a better impression with prosecutors.
Now, one by one, theyre offering up their findings.
That means over the next several weeks, youll see more bombshells from more fund groups as they queue up for a shot at absolution. I think there will be a lot more to come, former Securities and Exchange Commission Chairman Arthur Levitt told me late last week.
How lawmakers and regulators react -- revamping everything from the very power structures inside mutual funds to how they collect fees and report the costs to shareholders -- will leave a lasting mark on profit margins at the publicly traded mutual fund companies. While many of the largest fund families are parts of private companies (like Fidelity Investments) or are mere divisions of financial giants (like Bank of America (BAC, news, msgs)), a fair number belong to pure-play public companies.
Potential winners could be T. Rowe Price Group (TROW, news, msgs) and Franklin Resources (BEN, news, msgs). These two have been unscathed in the scandals so far. (T Rowe Price is up 45% so far in 2003; Franklin Resources is up about 30%.) The good guys will pick up business from fund companies that have broken the trust of investors with revelations of wrongdoing. So far, they include Putnam Funds, part of Marsh & McLennan (MMC, news, msgs), Janus Capital (JNS, news, msgs) and Alliance Capital Management (AC, news, msgs), but there will be more. The Invesco division of London-based Amvescap (AVZ, news, msgs), for example, is being looked at closely by investigators right now, sources say.
Other losers will be the publicly traded fund companies with high fees. A push by regulators for greater visibility of fees will expose those with the highest costs to investors, who will then shop elsewhere unless fees come down.
Fund companies with above-average fees, according to Morningstar, include Amvescap (which offers AIM and Invesco funds), Federated Investors (FII, news, msgs), Waddell & Reed Financial (WDR, news, msgs) and Gabelli Asset Management (GBL, news, msgs). Again, T. Rowe Price looks like a winner here. Its one of the few publicly traded mutual fund companies with below-average fees, says Morningstar.
Heres a closer look at some of the changes in store for the mutual fund industry, and how they will affect the stocks of publicly traded mutual-fund companies.
Falling fees will hurt many companies
Mutual fund shareholders pay a number of hidden fees, which give short shrift to the average fund investor, Spitzer told me on the phone last week. For example, when mutual funds buy stock, they often pay brokers "soft dollars," or some amount of money above the normal commission. In exchange, they get certain give backs from brokers. If those goodies include legitimate stock research, no problem. But too often, Spitzer said, the deals involve funny business.
The crass example," Spitzer said, "is that they take the fund managers out to dinner.
The hanky panky, however, can involve much larger costs for mutual-fund holders. Some fund managers, for example, have taken give backs in the form of computer systems that were used elsewhere in the fund company. That, essentially, ripped off the shareholders of the funds involved. There isnt anyone looking to see that mutual-fund investors are getting what they pay for, says Spitzer. Things of value get pushed back, but theyre not always of value to the real shareholder.
Another suspicious charge is the 12-b1 fee, which fund companies levy to pay for marketing. The theory is that existing shareholders benefit from more marketing because it attracts more shareholders to help shoulder costs. Sounds good. But the problem is, since fund companies were allowed to assess 12b-1 charges starting in the early 1980s, fund assets overall have grown 60-fold to nearly $7 trillion; but fees have shot up 90-fold, says Spitzer. So is the 12-b1 fee really working? Doesnt seem like it. Yet, as of last week, 5,344 funds charged the maximum 1% 12-b1 fee, and 13,598 funds out of 15,340 funds domiciled in the United States charged a marketing fee greater than .1%, according to Morningstar.
Some fund families, like Dreyfus, Franklin and Lord Abbett, even go so far as to levy the marketing fee at funds that are closed to new shareholders. I use that as an example of how lax our regulation is, Spitzer says. Why should a fund that is closed be charging a 12-b1 fee? It is crazy. The funds reply that 12-b1 fee, on a handful of funds in each case, can be used to support account maintenance and services. But an SEC spokesman says a maximum of only .25% can go for this purpose. Thats less than what these funds are taking in on 12-b1 fees.
To solve these and other problems, Spitzer is suggesting several reforms.
- Mutual funds need to offer much more detailed disclosure of fees. When you go into a store and buy a can of soup, there is a little nutritional chart that tells you the information you need, Spitzer says. I would like to see the equivalent form of disclosure that would break out what your mutual fund fees are used for.
- Funds should send out regular communications describing how much money is deducted for fees. That way, investors would really feel it, says Spitzer. Or else regular statements should include charts that show how much you lose in returns over 10 years because of fund fees.
- More importantly, boards overseeing fund companies have to be made more independent. That way, theyll have the freedom to do everything possible to bring down costs for investors. We have opened up an area that demands fundamental change, Spitzer says, because the board failure in the mutual fund context is at least as egregious as what we have seen in the cases of Enron or Tyco.
How it will all play out is unclear, but one thing is sure: The reform that's about to sweep the mutual-fund sector will put the spotlight on fees and make it easier for investors to see which funds are the priciest. As fund companies are forced to compete on price, fees will drop. Revenue growth -- and thus share prices -- at the costlier funds will suffer as a result.
Publicly traded mutual fund companies with above-average fees, says Morningstar, include Amvescap, Federated Investors, Waddell & Reed, Gabelli Asset Management and Eaton Vance (EV, news, msgs), for its international funds. T. Rowe Price, Janus and Alliance have below-average fees. Franklin, BlackRock (BLK, news, msgs) and Legg Mason (LM, news, msgs) have average fees. The average expense ratio for domestic equity funds is about 1.4%. For fixed-income funds, it's about 1.1%. International funds average around 1.9%.
Investors will shun tainted funds
Consumers typically forgive corporations fairly easily for high-profile, public blunders. But when it comes to the kind of trust needed to put your money with a fund family, they probably won't be as likely to look the other way. Weve already seen billions of dollars flowing out of fund groups in the middle of the mutual-fund scandal, especially Janus, Alliance Capital and Putnam.
But the losses for these fund groups could be even bigger if we really are on the cusp of an economic turnaround and another bull leg in the market. After all, thats a time when investors pump lots of money into mutual funds. These tainted groups will miss out on this opportunity to capture their fair share of those fund flows.
Indeed, money has moved into yet-untainted funds like Franklin and T. Rowe Price at a healthy clip in the past two months as investors have fled fund groups caught up in the scandals. Our flows have been very strong, says Steve Norwitz, of T. Rowe Price. The anecdotal evidence from the shareholder reps is that a lot of people are saying they are moving money from this firm or that firm because of what they are hearing about the scandals.
The stock of Marsh & McLennan may suffer less because its Putnam mutual-fund division contributes only 20% of the corporation's earnings. The rest comes from insurance and consulting divisions. Still, the stock is down 8% in the last month.
Mutual fund companies caught up in the scandals will face other costs their competitors won't have: fines and penalties, and any damages in shareholder lawsuits.
One thing that could help the shares of sullied fund groups is that, ultimately, investors might be willing to forgive if returns are big enough to help them look the other way. But the fact is, the fund groups caught up in the scandal so far also have among the least attractive funds. Alliance, Amvescap and Federated all have 25% or fewer of their large-cap funds awarded four or five stars by Morningstar. For Janus, the number is 35%.
T. Rowe Price sees 63% of its large-cap funds earn the top two Morningstar ratings. For Franklin Templeton, the number is 56%. Waddell & Reed clocks in at 77%. The industry average is 33%.
Plenty of time to invest
To be sure, there are plenty of positive factors that make the shares of any mutual-fund company attractive. Typically, these companies have excellent cash flow, since they have low capital costs and no minimum capital requirements, unlike banks and brokerages. Plus there is a wide array of tax incentives that favor investments in their products, such as the various tax-deferred retirement plans available to investors. And a bull market -- if thats where were headed -- always brings healthy cash inflows.
Bulls on these stocks like to point to the huge number of baby boomers in the 45-to-64, high-savings age bracket -- even if the growth of that age group probably peaked last year and will continue to decline now for many years.
Despite these positive factors, there will be plenty of time to pick up shares of the safer plays in the group -- like Franklin Templeton or T. Rowe Price -- because bigger mutual-fund scandals almost certainly will rock the group in the coming weeks or months.
Even I could not have predicted in early September the exponential growth that we have seen in the past 2 months in the number of companies that have been affected by this, Spitzer told me. As this has continued to expand, it is equally difficult for me to look down the road and say how many more mutual funds, hedge funds and broker-dealers will be affected. But we have a very significant number of ongoing investigations."
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