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Karen Gibbs and Geoff Colvin Karen Gibbs Geoff Colvin Geoff Colvin Karen Gibbs
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Air date: Nov. 14, 2003
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Mutual fund scandals

GEOFF COLVIN: The front-burner issue for investors remains the developing mutual fund scandal, which got even hotter this week. Richard Strong of the Strong Funds group learned he could face criminal charges. Charles Schwab announced it has found evidence of trading abuses, and American Express says it's in talks with the SEC over its fund trading - and the action is far from over.

So what's next, exactly how are you being taken, and what should you do? Senator Peter Fitzgerald, Republican of Illinois, has called the mutual fund industry "The world's largest skimming operation," and he has introduced a bill to reform the business. He joins us from Capitol Hill. Robert Rodriguez is CEO of First Pacific Advisors, a top-performing mutual fund company that has been cited in the press as one of the firms you can trust. He joins us from Tempe, Arizona. Edward Siedle has been called the Sam Spade of money management. He's a former SEC attorney who now investigates mutual fund companies on behalf of big institutional investors.

Mr. Siedle, so far we've seen just a few mutual fund companies actually charged with wrongdoing. How pervasive is illegal trading in the fund industry?

EDWARD SIEDLE: In the mutual fund industry, illegal trading is pervasive, and it's longstanding. It's been going on for the last 20 years, and it costs investors billions, andů

COLVIN: Pervasive meaning most firms?


COLVIN: What kind of illegal trading?

SIEDLE: There's all sorts of ways in which mutual fund insiders can benefit from trading, to the detriment of the investors in the fund. It can be front running trades -- doing trades before they trade for the fund. It can be allocating IPOs to themselves personally instead of allocating them to the fund, allocating IPOs or other securities trades to hedge funds instead of the retail mutual fund investors. There's a lot of ways.

COLVIN: And these are illegal practices.

SIEDLE: Some of them are illegal and some of them are what you'd call unethical or breaches of fiduciary duty.

COLVIN: Bob Rodriguez, you've been in this industry over 30 years. Have you witnessed what Ted Siedle is talking about?

ROBERT RODRIGUEZ: I've heard of them. I don't have any direct knowledge of individuals doing them per se. I know within our own firm we have internal controls as well as codes of ethics in reporting requirements that would preclude those types of things occurring in a firm such as ourselves.

COLVIN: Well, we'll get into the subject of fees later. Senator Fitzgerald, you're in charge of protecting your constituents. You also chair the subcommittee in the Senate that oversees these matters. After what we've heard, how can you sleep at night?

SEN. PETER FITZGERALD: Well, we really do have pervasive problems. The SEC Director of Enforcement, Stephen Cutler, testified at my hearing that they have surveyed all the nation's largest mutual funds and the largest broker dealers in the country, and they've found that illegal late trades are being facilitated by at least 25 percent of the major brokerage houses in the country. Furthermore, their preliminary conclusions are that as many as 50 percent of the mutual funds in America, that's one half of them, have been giving market timing capacity to at least a select few of their customers, potentially illegal activity that is certainly in most circumstances unethical and a violation of fiduciary duty to the funds' shareholders. So the wrongdoing is widespread. There's wholesale lawbreaking going on out there. We have to stop that immediately.

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COLVIN: Well, let's put a couple of things together. The Putnam whistle blower apparently went to the SEC months ago with evidence, and nothing happened. Nothing happened until he went to the Massachusetts state regulators. In light of that, plus the results you've just referred to, plus what Ted Siedle has described to us, is there some kind of deep, systemic problem at the SEC?

FITZGERALD: Well, I think the SEC was late in coming to the fight here and stepping up on behalf of shareholders in mutual funds. But now they are on top of it. They removed the head of their Boston office, who apparently did not pay enough attention to the calls of that whistle blower at Putnam. And I do believe the SEC is now getting on top of things.

But certainly, at least at the start, Eliot Spitzer in New York was leading the charge, and some other state regulators are getting into the act. I'm hopeful that the SEC will now understand. See, the mutual fund industry 20 years ago was only $115 billion. It's now $7 trillion. It's grown so quickly that I don't think anyone was paying attention as the industry was growing, and they didn't realize that it merits the kind of attention that we now realize it merits.

COLVIN: Ted Siedle, you've been in the fund industry at one point in your career. You've also been at the SEC. Do you share the Senator's confidence in the SEC's ability to do this?

SIEDLE: No, I don't. I think the SEC has become far to close to the Investment Company Institute and has been over the years.

COLVIN: That's the organization that represents the mutual fund industry.

SIEDLE: Well, on occasion they claim to represent the nation's 95 million mutual fund investors, but in fact they're a lobby group for the industry. They have a very close relationship with the divisions, with the SEC's Division of Investment Management, which I used to be a member of. And no significant legislation historically has left the division without the ICI vetting it. And I think that even from the actions I'm seeing today, the SEC still doesn't get the point that these violations are meaningful and they are quantifiable, cause quantifiable harm to investors. That's the point that nobody even today seems to be getting.

COLVIN: The SEC has just reached an agreement with Putnam, which Eliot Spitzer, the Attorney General of New York, has called "a joke." Spitzer has also said that the fundamental, the most fundamental issue facing the mutual fund industry is "how to create a governance structure that will drive down fees that have been raked out of investors' pockets for years by the management companies."

I'd like to ask all of you if you agree with that, starting, Ted, with you.

SIEDLE: Well, first of all, with regard to Putnam, as you may know, I used to be director of compliance and legal counsel to Putnam.

COLVIN: It was in the '80s, right?

SIEDLE: In the '80s. So I can't really comment on that. But I certainly agree that the greatest quantifiable harm to investors are mutual fund fees and the brokerage commissions paid by mutual funds, which by our estimates are at least 50 percent inflated.

COLVIN: Bob Rodriguez, your fees are notably low, even though you have actively-managed funds. Why can't they be so low for the rest of the industry?

RODRIGUEZ: We have worked on our expense and fee structure over the years. We're unmerciful about taking costs out of the system. And so our direct operating costs are really only about 9 basis points and our transaction costs volume are in the low single basis point area. So it can be done if you are looking at it.

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» Making sense of the mutual fund scandal

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But you have to recognize that in the last 20 years the mutual fund industry has grown from being one that considered itself a steward of capital to one that was viewing itself more as a gatherer of assets and a marketing organization. Thus, I look at many of the firms where some of these issues have occurred, (and I see that they) have been led by what I would call marketing-oriented executive ranks, whereas those types of firms that are headed up by what I would call investment-oriented executives probably have tended to have less problems there, and so it's very much -- we at our firm consider ourselves stewards of capital as opposed to gatherers of assets.

COLVIN: Senator, one of the provisions in the bill you have introduced would require a greater disclosure of fees. Most people would think that fees are pretty well disclosed already. What do you expect that to accomplish?

FITZGERALD: Well, the fees are not really fully disclosed. A fund is now required to disclose its expense ratio, but a lot of expenses are not captured in that ratio. Transaction costs are not captured. There's not really any way you can figure out the revenue sharing that is done with brokerage firms or the payments to brokers for referring orders into the mutual fund. And so we have to beef up the disclosures.

Eliot Spitzer is exactly right. The fees are way too high in the mutual fund industry. You can, if the mutual fund is run in an ethical manner, as Mr. Rodriguez has described his fund, they can lower the fees to investors. And those small differences in fees sound like just a little bit, but over time they, when it's compounded over 10, 20, 30 years, it adds up to enormous differences in returns to the funds' shareholders.

COLVIN: It can indeed add up to a huge amount. Let's take a look in fact, because investors pay $70 billion a year in mutual fund fees.

FITZGERALD: $130 billion, I think, if you capture all the fees.

COLVIN: If you capture all the fees. Well, $70 billion in what's stated and disclosed, in any case. Good funds, like Bob Rodriguez's, charge less than 1 percent of assets in fees. Bad ones may charge well over 1, 1.5 percent. The industry average is 1.3 percent. And as you say, Senator, those seemingly small differences do add up. If you invested $10,000 for 20 years in a fund earning a 10 percent annual return, if its fees were 1.5 percent, you'd end up with $49,000 and change, but if its fees were one half of 1 percent, you'd end up with $60,000 and change, a difference of over $11,000.

FITZGERALD: That's why this issue is so important to Americans. It's so important. There's $7 trillion out there now, and nobody has been paying attention to the level of fees that have been charged there.

COLVIN: Bob Rodriguez.

RODRIGUEZ: Yes, might I point out is that part of this rise in expense ratio is the changes in the various types of mutual fund A, B, C classes and whether they have trails that go along for marketing compensation. So a lot of the rising expense ratios in the mutual fund industry have come from that. There has also been a plethora of new funds that have come forward, and that has also biased the expense ratios up, because obviously smaller funds are less efficient.

And then the final thing I would point out is that what shareholders can look at is, they can look into their mutual funds and look for a little element, such as their expense ratio, and secondly they can look at the turnover ratio. And the turnover ratio really reflects the activity that goes on inside of the fund. So, for example, the industry right now has an average turnover ratio nearly 100 percent, or turning over the entire assets of the fund in one year. And many funds go up into the 200 percent and 300 percent level, whereas firms, such as myself, have turnover ratios that have averaged less than 20 percent over the last 20 years. That adds to the cost of running the fund and what these gentlemen are talking about.

So there is a number of things, but some of these things are already disclosed to the shareholder, but they're put in the, like the page 20, page 30 of a report, and are not talked about in the discussions by the fund, by the fund managers or even on the front page of their reports.

COLVIN: Ted Siedle, investors feel helpless now. They don't know where to turn with their money, don't feel they can trust anyone. What should they look for?

SIEDLE: Well, first of all, I think investors are exactly right. They should be scared. They should be worried. If losing half their 401(k) over the last few years didn't scare them, the current scandals should scare them. It should make them reassess, do they really want to take on the risk of the equity markets or bond funds or whatever, or should they be in a CD. There are some very real problems out there. We have not even begun to unearth the extent of the wrongdoing.

COLVIN: So this is going to get a lot worse.

SIEDLE: Absolutely. There's no question in my mind that the senior management of many of the leading fund companies have participated in wrongdoing, have been involved in criminal activity amounting to obstructions of justice. I think there's a lot more we need to find out. And so I would say to investors, be careful more than ever today.

COLVIN: What you're saying suggests that the survival of some of these funds could be in jeopardy.

SIEDLE: We strongly believe that. We believe that the wrongdoing is so longstanding, involving such significant amounts of money that it could very well cause some of these firms to crumble or survive in much reduced fashion. One of the things that we find when we investigate mutual funds is that our pension fund investors often pay one-tenth the fees -- one-tenth -- of what retail mutual fund investors are paying.

COLVIN: How come?

SIEDLE: They're getting it because they negotiate fees. The boards of directors of these funds are not negotiating fees with the advisors of these funds that handpicked them, so absent, effective negotiation, absent adherence to fiduciary duties. The fees are, our institutional investors pay maybe 10 basis points for money market management. Retail investors are paying 1 percent. It's not a slight markup. It's 10 times, and there's no reason for it.

COLVIN: Senator Fitzgerald, as I said, a lot of investors feel helpless, they don't know where to turn. What's your advice?

FITZGERALD: Investors really need to scrutinize the fees they are being charged. For the time being, they should try and refer to the Morningstar and Lipper ratings to try and get some guidance. They should search out the lowest-cost, best-rated funds. There are funds like Mr. Rodriguez's. There's also Vanguard, whose fees are much lower.

Ultimately I'd like every American to have the same kind of mutual fund options that federal government employees have. We have a $118 billion mutual fund. It's called the Thrift Savings Program. The expense ratio, total expenses, are 8 basis points on the federal program. The management fee is less than 1 basis point. The federal government competitively bids it out, and the federal employees are beneficiaries of very, very low cost.

Some members of 401(k) plans where their company has negotiated hard with the outside managers are doing well, but ordinary retail investors can absolutely get fleeced in mutual funds, so they have to do a lot of investigation, as has been described on this program, to make sure they're not being skimmed by excessive gouging on the fees.

COLVIN: Bob Rodriguez.

RODRIGUEZ: Yeah, I'd like to make one comment, and that would be is that actually investors have lost more money because they don't know what they own. In virtually every presentation I've ever made, I've asked the question, "How many individual investors out there, how many of you read your shareholder letters, your shareholder reports?" Invariably, it's less than 15 percent. So as a result of that, in my opinion, most investors don't know what they own.

And during the last four years, during this absolute debacle in the stock market, there has been such unmitigated rank speculation on the part of purported investment managers, and individual share owners didn't have a clue about what was going on. And so I would heartily urge them to read their shareholder letters, to read reports such as Morningstar, follow how often do the managers of their funds change, follow the names, what is the turnover of the staff in those funds. You have to, if you do any kind of minimal research like that, typically you find the better funds have a large element of stability in the management of the fund as well as in the management of the organization. And I think those are elements that reflect highly on many firms out there. And, by the way, I think there are a number of very honest, straightforward, ethical investment managers in the field today, because I know many of them.

COLVIN: Well, Bob, finally, you have mentioned a topic that we really haven't touched on so far, a vital topic, namely the stock market, up more than 35 percent in the past 13 months. Do you think it's overvalued?

RODRIGUEZ: Well, my shareholder letter is going out here within approximately two weeks. By the way, the first paragraph has comments on transgressions in the mutual fund industry in it. And then subsequently I talk about how we are going to be a net seller of stocks over the course of the next six to nine months, that optimism and speculation have risen to elevated levels in contrast to what we had written on our Web site and in our shareholder letters earlier this year.

So, yes, I do think risks are being elevated, and guess what? We now have large cash inflows into equity mutual funds that are touting performance for this year, as opposed to what has gone on over the last three years. And so in one of my comments in my letter I say, buyer beware, especially of some of the aggressive growth funds that are going on today that are doing many things that I saw going on in 2000 when I warned of the debacle that was pending in the U.S. equity markets in our shareholder letters as well as in several interviews.

COLVIN: Ted Siedle, Bob Rodriguez, Senator Peter Fitzgerald, thanks for being with us.

Student stock research

KAREN GIBBS: Professor Peter Ricchiuti, tell me the rationale behind the Burkenroad reports.

PETER RICCHIUTI: Well, we think there's a real market for research in the stocks that have kind of been ignored by Wall Street. We tend to focus on those companies that are market caps of $750 million or below, and they tend to be headquartered in the deep South here.

We have a program where we have 160 students. We divide them up into teams of four, and they cover 40 companies in this region. And these are generally stocks that have been underfollowed by Wall Street.

Also one of the things that we think is interesting is that when you visit a big company, you meet executives, but when you visit small-cap companies, you meet the owners. And we think it's great that a lot of these companies' managements have a big vested interest in the share price.

GIBBS: Aren't you assuming a lot of risk in investing in companies just in that particular region?

RICCHIUTI: That's true. We tend to get bunched in a couple of different industries that are headquartered here, particularly in the energy business. About 30 percent of the companies we follow are in energy. And when you look at it, these are the kind of stocks that ought to be sprinkled within a larger portfolio and not all of your money focused in this one region.

GIBBS: Are there any advantages of not being on Wall Street?

RICCHIUTI: Oh, I think there really are. I think when you're down here you tend to know the companies that we're talking with. You get to meet them. We go out to the -- we probably have the best field trips in America, Karen -- we go to steel mills and chicken-processing plants. If you've never been to a chicken processing plant, do take the family. That is a nice one.

You get a chance to meet the people, and we try to do all the extra stuff, Karen. We not only meet with the management on these company visits, but, you know, we're talking to suppliers and customers and competitors and trade associations. We really can focus on a specific region.

GIBBS: Well, your costs are probably pretty low, looking at a bunch of students here, but why should we listen to the information presented by a bunch of students?

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RICCHIUTI: Well, I think for one thing, they have no vested interest. There was never any conflict with investment banking operations or anything like that. And they really have put the time into it. On Wall Street you tend to be able to, oh, have to put a report together very quickly, one person. This is actually four students over a whole semester that are doing a lot of field work. They're working very hard at putting these reports together, and we're really pretty proud of the product.

On top of that, the kind of stocks we've followed have done incredibly well over the last four or five years. One of the things we're most proud of, Karen, is we've sent 375 students from this program on to jobs in the investment business, and it gives them a huge leg up because instead of just having a resume, they have a 20-, 30-page report they've written that really helps differentiate themselves from the other candidates.

GIBBS: Todd Speece, I understand that you cover Allied Holdings. Tell me why that's interesting to you.

TODD SPEECE: Well, it's an interesting stock because it's a typical stock that we would cover at the Burkenroad program. No one else on the Street follows it, yet the company has about 60 percent of the transportation market of new cars from the manufacturers to the dealerships. And over the past year, the company has been executing well, and the stock price has appreciated approximately 40 percent over the last year.

GIBBS: What other value do you derive from being involved in this class?

SPEECE: Well, it's a real unique opportunity to really get out there and have a hands-on approach to Wall Street and see what goes into a report, what do investors look for, what are the metrics in different industries, the different types of valuation, and really put it to work. You know, it's stepping outside of the classroom where you learn an equation and kind of regurgitate to the professor. It's learning this, looking at the industry, and then actually, not giving it to a professor, but giving it to an investor and allowing them to look at it and make an investment decision on your work.

GIBBS: Mirela Nicola, what stock do you cover?

MIRELA NICOLA: This year I'm supervising teams that are covering MidSouth and Iberia(BankCorp) in Louisiana. I think that banking is very interesting in Louisiana and in the South generally because these are companies that are very concerned about offering a personalized service to their customers and also have the resources to support growing businesses and residential mortgages.

GIBBS: You look at the companies' financials, but do you also take into account the big picture going on in the economy?

NICOLA: We are looking both at the big economy and at the companies' financials. We always try to fit in the Louisiana banking into the bigger banking in the U.S. and look at the companies through this perspective. We follow the interest rate trends and the general trends in the market, but we're also thinking how to apply those trends specifically for the companies we are following down here.

GIBBS: Peter, what are some of the other gems that you've discovered along the way?

RICCHIUTI: Well, we've found some great ones over the years. And one of the things that's been interesting, Karen, is 14 of the companies we've followed since '93 have been bought out, so that tends to happen when you find a good company and then kind of shine the light on them a little bit.

A couple of companies that we're interested in at this point is, for instance, a company very few people follow, Callon Petroleum up in Natchez, Mississippi.

This is a small oil and gas company that is very unusual in that it has interests in the deep water Gulf of Mexico, and that's a place we only find the big boys, the Exxon Mobils and the Chevron Texacos. And they've got a couple of fields, the Medusa and Habanero field, that are both going to be coming on line in the next several weeks that will double the company's production. So a lot of times we're interested in these companies for a scale perspective, the idea that a small, new development can have a big impact on that company.

Another company we've picked up recently that we're interested in is Russell Corporation.

This is the people that make the sweatshirts and the T-shirts. We went on a field trip to visit with them. Very interesting. They've also bought Spalding and Bike and have made a huge inroad into the women's athletic apparel market, which is a big deal.

And I guess the third one is a company just south of us here in Houma, Louisiana called Gulf Island Fabrication, which makes those big production platforms that are used by oil and gas companies in the Gulf of Mexico. And once again, not a terribly expensive stock.

I think so much of the market has been run up in here, selling at very high multiples. But if you look long enough, I think you can find some good bargains here.

GIBBS: It's also very interesting that a lot of these companies have their CEOs' wealth very closely tied with the stock performance. Now we've heard a lot of negative aspects of having a CEO's wealth so closely tied. What's your thought on that, Peter?

RICCHIUTI: I like to see management own big chunks of the stock. I mean one thing I jokingly say is that all the companies we have, the managers are all crummy golfers, because they really do focus all of their waking minutes on these companies. I think it's a positive.

GIBBS: All right. Mirela, Todd, and Peter, thank you very much for joining us.

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