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 trust. 

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."

 (By contrast, 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.  



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