KAREN GIBBS: Welcome to Wall $treet Week with FORTUNE. I'm Karen Gibbs.
GEOFF COLVIN: And I'm Geoff Colvin.
Who is picking your pocket this week? Almost every day we see more charges against more mutual fund companies in a historic scandal that just won't stop. But if you think you're scared, that's nothing compared with thousands of fund managers who are terrified by where this all might lead. We'll learn more about why. The fact is some fund firms are still safe places for your money. We'll tell you what they are. And while Eliot Spitzer and the SEC are making headlines, another major enforcer of corporate behavior is one you may never have heard of, but believe me, every CEO in America knows him well.
FORTUNE roundtable
Marc Gunther is a senior writer at FORTUNE magazine. Beth Fenner is a FORTUNE assistant managing editor, joining us from New York. Also in New York is FORTUNE senior writer David Rynecki.
David, you talk with a lot of mutual fund managers. How are they feeling right now?
DAVID RYNECKI: Well, first you have to think about guilt by association. You know, we've gone through three years of scandals and bear markets, and a couple of years ago when it was the analysts, well, it wasn't that big a deal to the average person.
Now if you're a mutual fund manager, this is really hitting home, because you can't use the excuse that this was a few bad apples in the bunch. You've got to explain exactly to your investors how you weren't involved in this. And quite frankly, they're looking at the entire bunch of apples as being spoiled
COLVIN: But do you think they're afraid because of simply guilt by association or are they afraid because a lot of these practices -- the late trading, market
timing and even personal trading abuses -- are really widespread and they might in fact be guilty?
RYNECKI: There are two answers there.
One: Yes, this is widespread and in some cases people are afraid that they're going to be guilty.
But most of the people that I've been talking to are generally of the more respected kind, smaller shops where they probably weren't involved in this. And yes, they're afraid of the association with the bad actions; they weren't involved but they're going to be linked to it anyway.
COLVIN: Beth Fenner, you have identified some firms and some managers who, you say, are doing everything right.
BETH FENNER: Right. And I think the important thing to remember is that there are -- sure, there are a lot of bad guys but they're not all, I'm not cynical enough to think they're all bad. And indeed, there are some who really are above board, and just are the kind of person that you want to give your money to.
COLVIN: Well, the list we have from you is Jim Gibson of Clipper; Bill Nygren, famous guy, at Oakmark; a five-person team at Tweedy Browne; another five-person team at Vanguard Prime Cap; and John Montgomery at Bridgeway. What have they done specifically to qualify for this list?
FENNER: Let me mention John Montgomery at Bridgeway first. They're sort of the epitome. They're a small shop in Houston. They charge just itty-bitty expense ratios, they're teeny. Montgomery won't pay himself more than seven times what the lowest-paid employee of the fund makes. They have policies to prohibit market timing, or to at least lessen the chances of it happening. They have a great letter to shareholders where they say what their philosophies are, and he has a lot of his own money in the fund, and if you are an investor in the fund you are just like the other people you are managing money for.
COLVIN: And that is a key trait that's great to look for in money managers. Marc, you have been looking into the 900-pound gorilla of corporate behavior enforcement, but it isn't Eliot Spitzer, it isn't the SEC. Who is it?
MARC GUNTHER: Well, Phil angelides is the state treasurer of California, and in that role, he oversees both the California state public employees pension fund, known as Calpers, and the state teachers retirement fund, which is called Calsters, which has been quieter in the past but is very much waking up now and they collectively have a quarter of a trillion dollars in investments, a huge amount of money...
COLVIN: A quarter of a trillion? $250 billion.
GUNTHER: $250 billion, yes, spread across the entire market, and so they have a big stake in both the integrity of the markets, but even moreso the confidence of investors.
COLVIN: So they have a lot of weight to throw around. How do they throw it around?
GUNTHER: Well, they've been extremely aggressive both with the SEC and at the New York Stock Exchange on all sorts of corporate governance reforms. Because again, if investors don't trust the markets and pull money out, and we remain in a slump or go into a slump, that hurts Calpers. That's their stake there.
They also do do business with virtually all the big Wall Street firms and mutual fund managers. So for example, they instantly took all their money out of Putnam last week; Putnam, by the way, is now looking at losses, or I should say withdrawals, of $40 billion, scandal-related. So we are seeing some market reaction to these scandals.
COLVIN: Well, let's talk about the market a bit. David, you talk to all these money managers. Aside from whatever they're thinking about the scandals, let's find out what they think about the markets. The markets are up close to 35 percent over the past 12 months. Do the people you talk to think that it's overvalued now?
RYNECKI: Well, it's an been an astounding year. When I talk to people, what I'm hearing it is not a whole lot different that what I would have heard a year ago or two years ago, which is the old standard: We expect single digit returns, we are stock-pickers by nature, all that kind of gobbledygook.
The one thing I have picked up on that is semiunique or somewhat unique comes off the economy. When you look at figures that are out this week -- about 8 percent growth in GDP in the third quarter -- that heartens some people. But for a lot of investors -- people like Bill Gross, for example, at Pimco and on down to your typical equity managers -- some of these guys are very concerned that that points the way to inflation. Surprisingly, we haven't heard that word, inflation, taken seriously in a few years, but when you talk about the economy getting hot and inflation, that's going to mean bad things for financials. Ultimately that could mean a slower economy down the road, and that's concerned a lot of people.
COLVIN: We see this so often. It's the most astounding, confounding thing. A fabulous report on economic growth this week. Result? These guys get worried.
RYNECKI: That's exactly how it happens. They look into the crystal ball and what they see is the Fed raising rates in the next year or two; the housing market imploding; banks -- not the big multinationals that are diversified with brokerages and investment banking arms, but more the regional banks that do a lot of lending -- they're going to get hurt if rates rise.
COLVIN: Beth, with all that's been doing going on in the mutual fund world, senators and representatives, predictably, are falling all over one other to get new laws enacted to regulate the fund industry. What are the odds they'll do something reasonable and not go overboard on this?
FENNER: I think it's sort of too soon to tell, but I think we will see reforms and we will see them pretty soon because, they like to strike when the iron is hot and this is topic A for everyone.
They'll probably do something to prohibit -- you know, fair-value pricing is something that everyone is talking a lot about. And that is, of course, when the prices get stale, they're set at 4 p.m. for the fund and people are then moving in and out of them and that's when the shenanigans start happening, and I think that (fair-value pricing) is a reasonable thing for them to require and I think that's something we should see.
RYNECKI: Hey Geoff, if I could interject in there...
COLVIN: Yes, David?
RYNECKI: What I think is interesting here, it's the same old argument we heard throughout the scandal the last few years. It's not really a question of what's legal, so therefore, I'm not sure this could be legislated to be corrected. It's not what's legal, it's what's ethical. These firms all say, "We're sorry for the appearance that we did something wrong," but not really admitting they did anything wrong. They're saying, "Well, we didn't do anything illegal," even though they did break the rules of their firm. I think that what's happening is just a general lack of admitting what's wrong with your system. And that's just a heart-felt reaction. It can't be legislated.
COLVIN: And it's a matter of corporate culture rather than legislation.
RYNECKI: Just like Tyco and Worldcom, these mutual funds have to be treated the same way by investors.
COLVIN: Mark, I want to talk to you about Phil Angelides, the treasurer, because he has political ambitions, this is clear, yes?
GUNTHER: He's going to run for governor when Arnold Schwarzenegger's term is up in three years.
COLVIN: Right. And it is possible, some people have argued, I mean, I remember when Calpers was seen as a great force for investors, going back, 10, 12 years ago, one of the real pioneers of corporate governance. Now some people say he is politicizing or may be politicizing what happens with that $150 billion of money. Is this a real danger?
GUNTHER: I don't think it is a danger, though he has his critics. And again, that's because Calpers is so broadly invested in the economy that they have a stake in the environmental health of the country; they have a stake in the social health of the country; and most of all, they have a stake in the financial integrity of corporate America. And that's why he's sticking his nose into all those places.
COLVIN: So if he wants them to divest tobacco stocks, which in fact they did, or to divest companies unfriendly to the environment or something like that, it's not going to be a big enough phenomenon to harm returns?
GUNTHER: That's the $150 billion question. But he would argue in the long term, companies that are able to externalize their cost may be okay for an individual investor, but if you're invested across the board, you're going to pick up those costs somewhere else in your portfolio. Again, the push is for corporate social responsibility but even more than that, financial integrity.
COLVIN: Hey, David, briefly, can you tell me what all those mutual fund managers you talk to think of Eliot Spitzer? Do they think he's doing what he has to do? Do they think he is a power mad government official? Or what?
RYNECKI: Well, it comes down two ways, okay?
If you're a fund manager and you can -- at Putnam, these guys that are strong, you're not liking Eliot Spitzer these days and you're thinking he is a publicity-seeking crackpot and you don't like him in general, right?
But in general, when you talk to the people who, for example, Beth has mentioned, the Clipper fund and guys like that, they're actually happy about this. They would like to have it dealt with, because they don't do these kinds of sleazy things. They want it out in the open.
COLVIN: Beth, what else characterizes these people you have identified? What should investors look for now in mutual fund managers?
FENNER: I think that, you know, one important thing is look at the expense ratio. You can go on Morningstar.com and look for that. You need to read the shareholder letters and do some research. When the manager talks about his fund and says stuff like, "All my money is in this fund, my personal money," that's a really good sign.
So the burden is on investors to do a little more homework perhaps than they're used to doing. You can't just look at the performance numbers for the past three years. You need to really look (and see if) "Is this the kind of guy I want to give my money to?
COLVIN: Great point. Beth Fenner, David Rynecki, Marc Gunther, thanks.
Mutual fund trading interview
GIBBS: Another mutual fund company that's taking a leadership role in the industry right now is T. Rowe Price. But for the professionals on the front lines, things are getting pretty tough, what with all the indictments and the ongoing controversy about how stocks are traded at the New York Stock Exchange. So we asked (T. Rowe Price) head trader Andy Brooks to take us behind the lines for a firsthand look at how the industry really works.
(video package begins)
Walk me through what you have to do if you were thinking about buying or selling a position or just monitoring a current position.
ANDY BROOKS: Sure. Well, certainly we own lots of stocks here and we have analysts and portfolio managers that follow companies and report on the progress of the company and make a decision on the valuation. And our job is when the decision is made either to buy or sell, to transact, we're the place that that is going to happen.
Perhaps the biggest part is just common sense and being clear on what your mission is. We have a lot of very talented people here, and if they want to buy a stock, it's my job to get it bought, and we have to try and do it in a thoughtful way. And you know, it's important, even though we're a mutual fund and investment advisory firm, we really represent a lot of individuals like you and those people get rolled up into an order, and that order goes to the marketplace, so in some respects our order is a microcosm of what we're doing globally. The individual investor needs fair treatment, but so does the institutional investor, because often they're one and the same.
We're in a period right now where everybody is being challenged for their profit motives, and everyone is being looked at very carefully, and there have been lots of transgressions, whether it's Dennis Kozlowski or Dick Grasso or anybody else you want to identify. And right now we're in the hot seat, our industry is.
We have an opportunity for change. John Reed is the new chairman of the New York Stock Exchange, at least on an interim basis, and there's an opportunity to take a fresh look at things. We do need to be careful and and try and be clear in what's right and wrong, and self-regulation is important. The industry historically has done a good job in self-regulation. It's coming under attack right now, but you know, the SEC and Mr. Spitzer and the New York Stock Exchange, and Nasdaq, the Nasd -- all those entities need to be ever-vigilant in looking at things and how things are happening. I think we all can support that process, and we all should be interested in the most transparency we can get.
Years ago, the specialists on the floor, those that sort of dictate the market and act as a traffic cop, used to make most of their money for performing a function of fair and orderly markets. That's changed. Today they make most of their money from a proprietary trading approach. And they're trading on behalf of their own interests, as opposed to their clients' or their customers' interests. One of the challenges, of course, is if someone is acting in a proprietary way, that's really adversarial, that's not in our interests, that's not in our clients' and customers' interests. And what we have is, I think, a chance to take a fresh look, try and separate the self-interest out of this process and really try and provide a better market, a better system, a better process, more efficiency, more fairness, more transparency, more disclosure, all those things that are good for people.
You know, the markets have served people very well here for 200+ years and we want to continue that. If we turn our attention towards performance and to the rules that are fairer, perhaps we'll get a better shake for all investors.
GIBBS: It's a little bit different in terms of what we're talking about with the specialists and technology systems. The mutual fund industry has come under scathing scrutiny this week, last week, in terms of fees, in terms of trading practices. What do you think about that?
BROOKS: Well, it's an uncomfortable position to be in. You know, a couple years ago, all the broker-dealers were under the gun and a lot of corporate America was under the gun because of governance issues. The mutual fund industry historically has not been tainted and has done a terrific job for investors. It's been a wonderful product for people to save for retirement and other things.
You know, there are going to be times when people do the wrong thing, and we're in one of those periods where some practices that some people thought were appropriate, it turns out they're not appropriate. It's unfortunate. I'm glad it's being identified, I'd like to get things out in the open. We work hard to do the right thing. Not everybody does the right thing all the time. It's an uncomfortable position to be in because I'm in this industry, we're in this industry, and therefore we're going to get caught up in that some.
But it does present us an opportunity to get better. And often you learn from your mistakes and things improve, because you've been challenged. I don't know what to say about the people that have traded for their own account and have done this late trading, market timing, and really have done things that would quite clearly put themselves in front of their customers and clients. That's just wrong and it shouldn't be tolerated.
GIBBS: And T. Rowe Price is not one of those --
BROOKS: Well, we're working hard not to be in that position. And frankly, everybody, in whatever industry you're in, you can't spend enough time trying to identify and eliminate conflicts of interest. We spend quite a good deal of time trying to figure out how to avoid conflicts of interests, and really operate only on behalf our clients. You know, one of the smartest things I ever heard was people who commented and say, we'll do well if our clients do well. And I think that's something we believe: If we do a good job for our clients, rewards will follow to us.
(video package ends)
Online banking and checks
KAREN GIBBS: Well, what's going on in the online banking industry?
HERB GREENBERG: In the online banking industry, you have a company called Checkfree, and Checkfree is, as public companies go, the only game in town.
But what's very important here, Karen, is that if you're going to say this is a great deal -- because this is a company that has a lot of buzz around it, or especially it had a lot of buzz around it a few years ago when its stock rose to $125 a share, and now it's down to about $25 a share -- but if you're going to look at that buzz you have to say, "Hmm, anybody else doing this?" And there is. And it's a private company, or at least it's part of another public company. It's a company called Metavante. And it's part of Marshall and Ilsley, which is a big Wisconsin bank. And they have been actually taking business away from Checkfree. And you have to factor that risk into this, and, you know, you don't often hear about the private side of the public buzz.
GIBBS: All this interest in online banking, certainly there are going to be some public companies coming in to compete. How come banks aren't doing this in house?
GREENBERG: Well, actually, some banks are. In fact, Bank One, which was a customer of Checkfree, recently said, "We're going on our own," and they basically left Checkfree and they're doing it internally. And several other big banks have done some segments of this internally, they're sticking with Checkfree for some of it, or using Metavante for part of it, but they're trying to bring some of it inside because the costs are pretty high and they, you know, for outsourcing, and you say, "Well, heck, I might as well save some dollars," because, you know, that's very important for banks, saving money. So you're seeing some of that for the large banks, coming inside, that's a real risk, Karen.
GIBBS: It's really interesting to think of boring banking as a growth industry all of a sudden. Isn't the growth potential already priced into Checkfree's stock price?
GREENBERG: I saw one analyst report who said the stock, he had a target of $27 on the stock. It's hard to say. The company isn't really making GAAP earnings yet. They're making money if you'll "X" out certain things. And the growth projections are that they'll do well.
What's very interesting about Checkfree is that even though they've lost some of these banks, their volumes have remained stable. So, basically, they've lost business, but they're still building business just from their biggest customer, which is Bank of America, which represents 20 percent of earnings, and its committed to be there for the next 10 years. They got some stock in return for giving them a guarantee of like $50 million for 10 years. So, but the fact is, more people who do business with Bank of America, and some of their other customers, are going online, you know, like gangbusters.
GIBBS: Well, if Checkfree is the winner, what company is the loser?
GREENBERG: I have to say Deluxe. Deluxe Corporation. Used to be known until 1998 -- 1988, excuse me, as Deluxe Check Printing. It's the largest printer of checks in the country. It's based in Minnesota. Good company, but in a business -- let me tell you how difficult its business is. In its 10K (annual report filed with the SEC), Deluxe says, "We believe that the number of checks written by individuals will continue to decline due to increasing use of alternate payment methods, and, the total number of personal business and government checks written in the United States has been in decline since the mid-1990s."
Karen, they're telling you that their business is sort of walking out the door.
GIBBS: Herb, you've got to love somebody that actually reads these 10Ks. Thank you. Is there any way for Deluxe to reinvent itself?
GREENBERG: You know what, they're trying. They're scrambling all the time. They're trying to get you to take more, they're trying to upsell you to more expensive checks with designs and fancy things on them. And they're also actually getting some of the banks they do business with to give -- let them do the actual, you know, have you call Deluxe to do the ordering directly so they can upsell you. You know, it used to be you called your bank directly, but now Deluxe is getting a lot more of those calls.
GIBBS: Well, how about it, Herb, are you joining the 21st century or are you still doing it the old fashioned way?
GREENBERG: We're still doing things the old fashioned way. My wife's the bookkeeper in the family. She still writes checks. But the reason for that is we deal with a bank that doesn't have all these bells and whistles and instead they give us a higher interest rate.
GIBBS: interesting. So there's always a trade-off.
GREENBERG: always.
GIBBS: Herb, thank you very much.
GREENBERG: Sure.
Next week: Tour the globe for investments. Brazilian coffee anyone?
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