Icebergs and Mutual Funds: the still hidden scandals


Mutual Fund scandals continue to hog the financial headlines, growing in
scope, and continuing to surprise absolutely no one. Sure the problems within
the
industry are real,
but they do not lie in the overseeing capabilities of directors, the late
trading activities of big hitters, or the conflicts of interest/bed sharing of
the Mutual Fund Companies and their brokerage firm cronies. These
“discoveries”
[documented for many years by this writer, and summed up in “The Brainwashing
of the American Investor”] certainly deserve attention, but the real problems
with Mutual Funds, the 85% that lies below the surface, are different and
still roundly ignored.

All the investigations, all the reporting, all the hype is focused on the
visible portion of a huge iceberg of problems. Anyone foolish enough to think
that a salesman is not being compensated for selling something is being a bit
naive, don’t you think, even without full disclosure. But what lies beneath
the
waterline is much more important and requires, no, demands attention! There
are at least three major problems with Mutual Funds, and it may take more than
one release to examine all of them: (1) Investment Discretion…who has it? (2)
Investment Management…what are the goals and objectives? (3) The delivery
system
…how investment professionals are compensated

INVESTMENT DISCRETION

The Mutual Fund concept is sound and it still works fairly well in the
surprisingly unpopular (safer, and relatively unknown) “closed end” area.
But in
the “open end” format that 99% of all investors have been forced to become
familiar with, it suffers from a relatively new development that will be
difficult if not impossible to fix. I have to back up a minute to the
old days, to the development of the concept in the first place.
Theoretically, the attractiveness of a Mutual Fund is based in the relative
safety that
comes from a diversified portfolio and the day to day, transaction by
transaction, attention of a professional manager. Once open a time, fund
portfolios were
designed and managed by one person, in accordance with a well defined strategy
that included parameters for buying, holding, and selling. Requirements for
selection were well documented, and the discretion for all decision making was
solely in the hands of the professional...the manager.

Most often, Mutual Funds of this nature were part of an employee benefit
plan, and the selection of the management company was the responsibility of the
Trustees of the Plan.
Manager Performance was dealt with by comparing the fortunes of the fund’s
unit value with market averages between events in the past that were called “
peaks” and “valleys”. Rarely
did the trustees change managers and “in” or “out” decisions, both micro
and macro, were solely in the hands of the professional. The Trustee hired the
manager and the manager
exercised the discretion. Only one equity portfolio was available. Enter the
era of the low-cost Employee Benefit Plan, and the incredibly foolish idea
that the employees themselves were capable of making investment decisions, and
two sacred institutions were destined for failure.
Defined Benefit Pension Plans were expensive to manage, to administer,
and to “sell” to ever more mobile employees. Savings Plans, 401(k)s,
403(b)s,
various types of specialty IRAs, etc., on the other hand, were cheap,
inexpensive, and they didn’t cost much. Coupled with company stock options,
they became
an attractive, hands on, gift to employees that was theirs right now, and
transportable if they chose to move on to another employer. An additional
benefit
to employers was the elimination of actuarial expenses, management fees,
liability for mismanagement, etc. What they failed to explain to their
salivating
employees, the newly appointed investment managers, was that they had given up
a guaranteed retirement benefit for the opportunity to run their own
portfolios into the toilet. If the investigators choose to investigate further,
I have
no doubt that they will find a direct financial connection between an
Employee Benefit executive or two an either Mutual Fund Executives or salesmen.

So what did this enormous shift of financial power from corporate trustees
to all varieties of every day employee types achieve? Was investment discretion
still in the hands of the portfolio manager? Did anyone really care? Two
things happened for certain: hundreds of investment companies, big and small,
created thousands of Mutual Funds to attract the
newly created pools of unsophisticated dollars. Employees were expected to
choose between a variety of funds of all different types, orientations, and risk
levels. Management track records were provided, of course, but risk was
rarely considered and the operational realities of fund management were never
explained. Investment Discretion had been irrevocably passed from the
professionals
to the amateurs, much to the delight of Mutual Fund companies and brokerage
firms everywhere!

As an investment manager myself, its easy to explain the dilemma. If more
individual investors are excited about the prospects for the stock market than
are fearful that prices have risen too far and too fast, money will move into
the Mutual Funds. The professional managers then have a serious problem or two
that they inevitably have difficulty reconciling.
Mutual Fund charters require that the money gets invested, regardless of what
the manager himself wants to do. There is no flexibility. Buy they must.
Also, fund managers are evaluated on the basis of their quarterly
“performance”
numbers. Waiting for lower stock prices just doesn’t cut it. Thus, even though
its common knowledge among managers that the market is a cyclical beast, few
managers have the courage to stop buying high priced securities for fear of
losing their jobs. They just cannot be the first one either to start selling or
to close the fund to new investment dollars. Consequently, open end Mutual
Funds have evolved to the point where the inmates are in charge of the asylum!
Investor greed takes over, fueled by both the media and the financial community,
and the managers are managers no more! For whatever reason, the stock market
has become a financial “Planet of the Apes”, an inverted economic society
where higher prices are a symbol of safety and not risk. This is where we are
today.

After a few more months of rising prices, no one will care about the
manipulation, the conflicts of interest, or the inappropriate advise. It'll be
Deja Vue All Over AGAIN…AGAIN!

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Steve Selengut
steve@...
800-245-0494
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