November 26, 2003
The problems in the mutual fund industry once again reflect
a failure to recognize the risk relative to the gain that can be achieved from
financial decisions. This failure
to understand the risks associated with financial decisions was so well
reflected in Tom Wolfe's "masters of the universe" observation in his
book, The Bonfire of the Vanities.
Arthur Anderson exhibited this complex when it allowed a
close relationship between the auditor and the audited and then ignored the
advice of Paul Volcker, who was trying to save the company.
Martha Stewart was indicted for possibly exhibiting the same failure to
understand the risk associated with her stock sales.
Fund managers knew that trading on information not yet
allowed to be reflected in stock prices was illegal. Nevertheless, they allowed large "customers" to
purchase fund assets at a fixed price after new information clearly would have
altered that price. Indeed, some
managers apparently did the same thing for their own accounts.
As a result, these special transactions received guaranteed
returns that otherwise would have accrued to the investors already owning the
funds. As Jane Bryant Quinn
reflected in a recent column, this was stealing, even if the amount stolen from
each investor was only pennies a day.
Then we have the failure to inform investors of sales
incentives used to steer investors into preferred funds (meaning especially
profitable to the sellers). Also,
some funds that discouraged in and out trading for its core investors, allowed
such trading for large customers. Failure
to disclose or to allow some customers access to services not provided to
others, again showed disdain for the risks associated with the loss of investor
What were some of those Putnam managers thinking when they
juiced up their assets under management by allowing market timing transactions
for some customers? Did they really
believe that investors would maintain their trust when they discovered that
higher costs might have been paid by all to allow special transactions by some?
I remember once hearing a bunch of petty criminals lament
that they got caught but never that they did wrong things.
At least many of those were high school dropouts and may not have
realized the risks associated with their behavior.
Many fund managers have MBAs and should have had classroom examples in
considering risk in decision making.
Of course, some are arguing that risks were considered but
rejected because regulators were asleep at the switch.
After all, the mutual fund scandals became public because of filings by
Eliot Spitzer, the New York attorney general, not the Securities and Exchange
Commission. Indeed, the current
urban legend is that Spitzer heard about the behavior from cocktail party
chatter, as these practices were well known among managers.
Just as the final outcome for Arthur Anderson greatly
exceeded any gains that accrued to that company from inappropriate behavior, the
final outcome to Putnam appears to be lost assets and management fees that will
greatly exceed the temporary bloating of assets that the questionable
transactions created. Indeed, when
fines and profit restitution are added to the list, was reason really used in
making those unethical and/or illegal decisions?
Frankly, I have no explanation for the absolutely wrong
decisions made by some mutual fund managers with respect to these tainted
transactions. Perhaps they did
think they were "masters of the universe."
I understand why the preferred investors sought those transactions.
So far, their risks appear to be less than their rewards from good
investment performance. Somehow I do not believe the hedge fund and other investors
who got years of above market performance will abandon those who used these
transactions to juice up their performance).
I actually hope that investors move away from the offending
funds. First, it imparts costs for
bad behavior. Second, redemptions
will force less than optimum sales, hurting performance for those who stay.
Third, forced redemptions might also create taxable gains just as the
performance of the fund is sinking.
However, the scandal probably will have limited impact upon
equity values. Redeemed funds must
be put to work elsewhere. Even if
investors remain in funds that abused their trusts, they will lose the value
that would have been created by
better investment management, not the value of their investment.
But I seriously worry about fund managers who do not understand risk in their decision making or the environment that allowed them to under estimate the risk associated with their behavior.