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Uncovering the fund managers' dirty little
secrets
Heydon Traub, Boston Business Journal,
October 3, 2003
The money management industry has come under the gun over the last month
after amassing a very clean record over the last 60 years. Meanwhile, the
Wall Street brokerage firms were taking it on the chin for the last few
years for things like biased research, touting wildly overvalued stocks and
favoring certain people such as CEOs they hoped to do work for.
But now the money managers are facing the regulators' ire. The most
egregious charge is that Bank of America let at least one manager (Canary
Capital Partners) trade their mutual fund shares after 4 p.m., the usual
deadline, since that is when the U.S. stock market closes. Since there may
have been news that may have affected prices between 4 p.m. and Canary's
trades, they had an unfair advantage to trade at artificially better prices.
And this is not a victimless crime. Since Canary was getting too much value
when they sold, there was less money in the fund for the other fund owners,
leading to worse returns for them.
The other recent issue concerns market-timers. This is not that different
than the Canary scenario, except it is not a clear violation by the money
manager and not a violation at all by the fund owners doing the timing. The
difference is that these trades are completed before the noted deadline.
However, in funds such as international equity, most of the fund prices are
based on the foreign stock exchange closing prices, which may have occurred
as much as 16 hours earlier. Again, there can often be news in that span of
time that would have changed the price if it were trading. So if the U.S.
market tanks in the afternoon, when most foreign exchanges are already
closed, a market-timer would sell their shares in the international fund
knowing that when those stocks trade again, they will likely be at lower
prices than is being used to price the fund. And in addition to getting
better prices than they should, market-timers also force the fund manager to
incur higher turnover to accommodate all the trading, leading to excessive
trading costs. All of this leads to worse returns for the other funds'
shareholders.
Some fund companies have taken appropriate steps to foil market-timers. Some
put a ban on the timers using their funds, some put fees on excessive
trading and some limit the number of trades to, say, one per quarter.
However, there are some that have done nothing to minimize the negative
impact of timers.
At the risk of piling on, there are several other, more subtle things that
most money managers are "guilty" of -- but which, for the most part, are
legal, although they lead to worse returns for fund shareholders.
Most managers use soft dollars. This term refers to commission dollars paid
for trading shares of stock. As you know, the average online investor can
trade for somewhere around 2 cents a share, some a bit more and some a bit
less. Yet some of the largest managers in the world do some trades at 5
cents or 6 cents a share, and sometimes more. They aren't merely being
careless with your money -- the higher-than-normal rates are used to pay for
"research" provided by the broker. This was the original intent, and it
sounds reasonable, since the higher commissions might be more than offset by
buying better stocks based on the research. However, this has been allowed
to include paying for things that are not research, such as data, software,
performance measurement, consulting fees and, in some egregious cases,
things like rent and phone charges. Worse, because it doesn't come out of
the money manager's pocket, often more services are used than are absolutely
needed and the vendors charge higher prices for items paid via soft dollars.
Earlier this month, TheStreet.com published an interview with Ted Aronson of
Philadelphia-based manager Aronson, Johnson & Ortiz. In it, he estimates (on
the low end) that soft dollars lead to additional trading costs of $1
billion.
A more evident, though still somewhat hidden, questionable cost is the 12b-1
fee. These are used to pay distributors of the fund, essentially companies
or salesmen who help bring in investors. The idea behind the 12b-1 fees is
that the bigger the fund, the easier it is to lower the expense ratio, since
the various fixed costs are spread over more assets. In reality, this is
more like a hidden, ongoing sales charge and typically has done little to
lower expense ratios. In fact, there are funds that are closed to new
investors but that still, somehow, justify charging a 12b-1 fee. Aronson
estimates that 12b-1 fees, soft dollars and some other items cost about $10
billion a year.
Information on soft dollars is tough to uncover.
Those equity funds that don't use soft dollars probably will make an effort
to tout this fact. However, it is estimated that 90 percent of managers use
soft dollars, so you don't want to exclude all of them. One solution is to
focus on index funds that trade very little, other than to accommodate
flows. If they are not trading much, soft dollars will be minimal.
12b-1 fees are part of the expense ratios and are disclosed in the fund
documents. Worry more about the overall expense ratio, which includes the
12b-1 fee, and favor those funds with lower expense ratios (and no sales
loads).
Lastly, favor funds that have performance incentive fees or management with
substantial assets in the fund. The latter may be hard to determine, but in
both cases any extra trading costs are at least shared directly by the
manager.
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