ANALYSIS: Recovery of fund industry hinges on rebuilding trust

Fund companies will not be able to defend their reputation until they begin to talk more to individual investors, some of whom are pulling out.

Fund companies will not be able to defend their reputation until they begin to talk more to individual investors, some of whom are pulling out.

Lauren Young, department editor of personal finance for BusinessWeek, has covered the mutual-fund industry for 10 years, working for both Dow Jones and SmartMoney magazine. As a swarm of media controversy now engulfs the industry, spurred largely by New York Attorney General Eliot Spitzer's investigation into alleged insider dealings involving several prominent funds, she's seen a wide range of reactions. These include overtaxed fund-company PR pros to the people she comes across in her everyday life. "People in the company, in administration, are asking me about their investments. My parents are asking me about their investments," she says. The fact that the mutual-fund-industry scandal has permeated the consciousness of its 90 million consumers reflects the depth of the crisis. Nearly every media story about the mutual-fund reputation crisis thus far has included the statistics that the industry manages $7 trillion in assets and nearly half of all American households own mutual-fund shares. It is no surprise, then, that the story has become as wide-reaching as it has, invading the mainstream press and provoking many questions about things that were once taken for granted. Daily developments demonstrate that not only has the heretofore pristine image of the industry been tainted, but that the problems are widespread, with possibly dozens of organizations betraying the confidence of an American public that formerly saw mutual funds as one of the safest ways to invest in equities. Regulators, including Spitzer, have found that a number of funds allowed insiders to profit at the expense of small investors through illegal late trading and quasi-legal market timing, a practice that is to the detriment of all shareholders, especially long-term ones. In an SEC review of 88 companies responsible for 90% of the $7 trillion, half allowed at least one large investor to practice market timing. Regulators say that these practices give insiders the opportunity to profit at the expense of smaller investors. That is why reputation is crucial to every company. The sheer number of people who entrust their retirement money, save for an education, or invest their life savings in funds is staggering. Not only do they trust the companies with their money, but they trust fund managers to make decisions in their investors' best interests, not take advantage of the trust to profit for themselves. The consequences so far have been devastating to the individual companies' reputations. A November 24 Newsweek article about mutual funds opens with the lead, "One thing you can count on: When you invest, a lot of the people you trust are going to cheat." Investor pullout Since Putnam Investments first announced late last month that it was under investigation by Spitzer's team, the embattled company has seen investors pull out $7 billion in assets from the company's funds. And Massachusetts, among other states, has withdrawn its home-state pension money from the company. Putnam is also facing several class-action lawsuits. Fund company Fred Alger has also lost business, and Alliance, Bank of America, Bank One, Federated, Janus, and Strong have all seen investigative action, though much of it is still underway. Last week, Morgan Stanley, Bear Sterns, and Charles Schwab entered the spotlight of improper fund-trading practices. As a result of legal action, many PR practitioners at companies have released letters to shareholders, website updates, and official statements, but few are talking directly to reporters. Some reputation experts say these responses are not expected to be sufficient for too long, especially as investors withdraw money during growing skepticism. Some have hired specialty crisis firms, while others are seeking counsel from their agencies of record. When Spitzer first turned his sights on the mutual-fund industry after taking on the brokerage firms and analysts in 2002, many investors got a bad case of deja vu, remembering embattled Wall Street giants and a flurry of press reports filled with accusations and candid private e-mails. As Spitzer revealed that Merrill Lynch analyst Henry Blodget was recommending stocks that he privately disparaged, Merrill issued a release questioning Spitzer's grasp of financial dealings, alleging that he took information from Blodget's e-mails out of context. But at Merrill's 2002 shareholder meeting, CEO David Komansky backed down, and admitted that the firm needed to pay for its misdeeds. However, when facing a similar investigation into the practices of market timing and late trading, fund companies and brokerage firms raised the white flag and vowed complete and utter cooperation with Spitzer's investigation. The first firm targeted by Spitzer, Bank of America's Nations Funds, didn't speak out about the situation or attempt to make excuses. It simply fired people who were suspected or guilty of violations of these rules, a severe contrast to Merrill's fighting words at the outset of the analyst investigation that began in 2002. "Bear in mind the adage that bad news comes in threes," says Michael Weiser, chairman of IR shop The Weiser Group. "First we had the issues with accountants, then we had the issues involving the Street, and now the issues involving mutual funds. The mutual funds have had the benefit of watching the various forces who have positioned themselves on the issues. It's a little like the person sitting to the left of the dealer in a poker game. He or she is in a better position. The mutual funds have an advantage in understanding the coalitions and the constituencies in understanding the impact that public opinion has had on their reputation." Despite all of these advantages, affected companies are still suffering because there is no real leader for best practices. "I talk to a lot of people in the industry, and my impression is that people think that the fund companies have not been proactive enough in dealing with the issue," says BusinessWeek's Young. "People are nervous." Others say that companies have a tendency to wait for one of their peers to make the first bold public move. "I think there's been a bar set already," says Hollis Rafkin-Sax, vice chairman of Financial Dynamics. "You always wait for a leader to do those things without having the SEC breathing down their neck, and that hasn't happened yet." But will the mutual-fund industry ever fully recover? Comprehension before recovery "Many funds are just beginning to understand the depth of their problems, and that they are well advised to circumscribe their public commentary. I think it may have less to do with their lack of desire to be forthcoming - though there may be some of that - than it does with understanding the full nature of the problem and the issues surrounding it," says Weiser. In other words, actions speak louder than words. "If the market turns up, that certainly helps," says Rafkin-Sax. "But those who have credibility and a level playing field are those who have the greatest chance to reap the benefits." But the key will be to protect smaller investors, a priority that Spitzer made clear in a November 17 New York Times op-ed. Rafkin-Sax says, "Some of the financial-industry reputation crises that hit prior to this didn't touch the small investors, and that raises a different specter. When there's a personal story, it creates a new sense of urgency." Young says that in the meantime, investors will move their money, but they have more to worry about in terms of trust than in terms of financial loss. "In the long run, this will not be something that will significantly affect share value," says Young. "Despite some companies' problems, mutual funds are still one of the safest investment options. If they do a good job of getting the story out, then the impact on the investor will be relatively small."

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