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Spitzer's Domino Effect

The mutual-fund scandal started with a crackdown on mind-numbing technicalities. Look what it's wrought

Sep 15, 2004 | Newsweek

The big news on the investment-crime front last week was the 18-month prison sentence dealt out to convicted felon Frank Quattrone, formerly a star investment banker at Credit Suisse First Boston, for obstruction of justice. But while Wall Street focused on Quattrone's sentence, the first anniversary of the mutual-fund scandal came and went largely unnoticed. Too bad, because while Quattrone's fate is of concern mainly to Wall Street insiders, mutual funds affect almost all of us.

There's actually good news on the fund front. That's surprising, because for all the perp walks and posturing by regulators and commissions, skepticism is usually rewarded when it comes to anything really changing on Wall Street.

New York Attorney General Eliot Spitzer made a huge splash just after Labor Day last year when he exposed funds that had let well-connected investors skim profits from regular investors in complicated ways. Given the technicalities—can you really explain how "market timing" hurts small investors?—and the fact that so much fund investing is done on autopilot, it seemed that the industry would fork over a few bucks and make some cosmetic changes, and life would go on as before. But it hasn't.

One reason is that Spitzer awakened the Securities and Exchange Commission, which regulates mutual funds. More important, Spitzer started a domino effect by attacking funds' fees and lack of oversight rather than confining himself to strict legalities. He extracted fee reductions from funds to settle cases. "We're trying to get competition on the fee front," Spitzer said in an interview. "We want to invigorate funds' boards of directors to look out for their investors."

Spitzer and a tough Massachusetts regulator extracted a total of $3.2 billion in compensation, fines and fee reductions from nine fund families. This has helped kick off a price war of sorts, with some untainted fund outfits slicing fees to stay competitive. A notable example: No. 1 Fidelity's recently shaving some index-fund fees to compete with No. 2 Vanguard.

In addition to stimulating fee competition, the fund scandal has shown how valuable a good reputation can be. Bad actors are seeing investors flee, taking their money with them. The four fund families that I consider the worst actors—Strong, Putnam, Janus and PBHG—have seen the assets in their stock and bond funds fall between 17 and 24 percent since the scandal broke, according to data from Morningstar, a financial-analysis company. Meanwhile, the industry as a whole saw assets increase 17 percent.

And here's an even more dramatic way of looking at things. Morningstar gave NEWSWEEK statistics on 21 fund families that have been named in the scandal. Their assets have risen just 2 percent since the scandal started—and are down if you exclude the Pimco funds, which were barely grazed by scandal. But the assets of nontainted funds rose a whopping 22 percent.

That's huge. Especially when you consider that each added dollar of assets produces fees that are almost pure pretax profit, and each decline is a hit to the managers' bottom line. The prospect of having money bolt out the door has got even the greediest managers scared straight—at least for now. "Salesmanship had supplanted stewardship," says Don Phillips, managing director of Morningstar. "People marketed mutual funds as if they were toilet paper" rather than serious investments. Now, for a while at least, toilet paper has gone out of fashion.

Things still aren't perfect. Some of the new rules adopted by the SEC seem more about form than substance; they'll add costs that investors will bear, with little or no benefit. Lots of investors pay very high fees for only mediocre performance. Large investors pay rock-bottom fees because they have clout, while small investors—especially in retirement plans where their employers pick the funds—have no bargaining power. Players like Dick Strong of the Strong Funds, who admitted to skimming his investors to benefit himself, ought to be banished to the financial wilderness with the mark of Cain branded on their foreheads. Instead, Strong was allowed to sell his fund business for hundreds of millions of dollars. Ironically, the problem that kicked off the scandal—the chance for well-connected investors to trade after the markets had closed—still hasn't been fixed.

But let's not forget the big picture, which is this: the market has finally started to work. Watching fees fall, however slightly, isn't as satisfying as watching a good perp walk. But it helps a lot more people.


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