Wall Street WARZONE

Conflicts-of-Interest: 25 Tricks the “Happy Conspiracy” Uses to Secretly Skim Money from $12 Trillion of Your Mutual Funds & 401(k)s

by Paul B Farrell, JD, PhD
| | 5/8/2010

All across Wall Street, Washington and Corporate America, we see our leaders using our investment and tax dollars as their personal piggy-banks. Before the subprime-credit crisis, your fund managers were doing every day, billions skimmed. They control the bulk of Main Street’s retirement money. And unfortunately, you’ll never know how much they are siphoning off the top of your returns, although research by independent experts tells us their “take” reduces your returns by 30% or more.

How do they get away with with this robbery? While the SEC at least requires some minimal disclosures from Corporate America, the fund industry gets away with murder. Congress protected them by specifically exempting mutual funds from the disclosures required of corporations by the Sarbanes-Oxley Law. Of course that makes no sense. Why? Because funds control $12 trillion of Main Street money, your money, and yet that blanket exemption from disclosure lets America’s fund managers operate like the CIA and the Mafia, hiding behind a “code of secrecy” with a virtual license to steal.

High-priced lobbyists “protect” fund managers from their own investors

Worse yet, the industry’s trade union, the Investment Company Institute, is the investor’s worst offender. Armed with a huge budget, ICI attorneys and lobbyists consistently block attempts to expose how fund managers’ hide the truth from America’s investors. The truth is, fund managers are engaged in a conspiracy that is hiding one of America’s biggest conflicts-of-interest. Money magazine published a list of fund companies implicated in wrongdoings during the 2002-2004 scandals, a virtual who’s who of the industry’s brand name leaders: Alger … Franklin Templeton … PBHG … Alliance Capital … Invesco … Prudential Bank of America … Janus Putnam … Bank One … Merrill Lynch … Smith Barney … Charles Schwab … Morgan Stanley … Federated … MFS … Strong … Wilshire.

Yet, after an endless series of investigations, trials and Congressional hearings, the Senate killed the reform legislation, tossing everything back to “business-as-usual” with a weak, pro-management SEC. Little has changed today. The industry still operates behind a code of secrecy which allows fund managers and owners free rein to use $10 trillion in Main Street’s money as their private piggy bank—with very little disclosure.

Nor should you expect much change in the future. Given the enormous lobbying and political donor clout that the powerful ICI and the individual fund owners marshaled when they assaulted and defeated the Mutual Fund Reform Act of 2004, it is highly unlikely any reform legislation will ever pass Congress nor will the pro-management SEC pass regulations that do more than give the appearance of protecting investors, and then only with the tacit approval of the fund industry and its lobbyists, backed by an enormous warchest of campaign donations.

25 conflicts-of-interest protecting Wall Street, hurting Main Street

Here’s a long, detailed and by no means complete list of conflicts that continue today. We include them to let you know how protected the industry is, and to let investors they’re playing in a casino where Wall Street and their friends absolutely control the tables and set the rules, where the games are fixed, where the playing field is not level, and where the odds are stacked against you. The casino always wins, always—and here are 25 big reasons why they get away with it, year after year.

1. Failure to disclose manager compensation
Industry surveys tell us the average fund manager makes over $400,000, that’s ten times what the average American makes. Ten times! And yet the vast majority of their funds are performing below their indexes, even in good times. Investors are at least “entitled to know what kind of incentives motivate each fund manager,” says Roy Weitz, who operates the “FundAlarm.com” investors watchog site. “If one manager receives a bonus based solely on performance, and another manager receives a bonus based solely on how many dollars a fund accumulates, shouldn’t you know?”

2. Failure to disclose manager holdings in his fund
Insiders call this: “Skin in the game, money on the line, or eating their own cooking.” But however you describe it, Weitz says, “a manager who also has a substantial investment in your fund is almost certainly more focused and motivated.”

3. Failure to disclose buy/sells in timely manner
The standard manager fear is that “frequent disclosure of buys/sells would allow professional traders to ‘front-run’ or piggyback on a fund’s investment moves,” notes Weitz. So today’s reported data leaves investors with data that’s 6-12 months old. Absurd? You bet. The average fund turns over it’s entire portfolio more than 100 percent annually: “Quarterly disclosure with a three-month lag gets rid of the front-running issue, and there are simply no other legitimate reasons not to disclose this kind of information.”

4. Failure to disclose all of a manager’s commitments.
“In a perfect world, 100 percent of your manager’s time would be devoted to your fund,” says Weitz. But, “in the real world, your manager may be responsible for running literally dozens of other mutual funds, hedge funds, and private equity accounts. You’re paying for your manager’s time and attention. You have a right to know how much you’re really getting.”

5. Failure to disclose changes in managers and sub-managers
FundAlarm.com is a clearinghouse for this kind of information. Yet, Weitz and his viewers have to dig up the data on their own: “All funds (other than ‘team-managed’ funds) are eventually required to disclose manager changes to their shareholders. But with today’s technology, there’s no reason that every fund with a Web site shouldn’t prominently disclose manager changes within a day or two after they happen.”

6. Failure to properly report how 12(b)1 fees are spent
“Your fund may be taking a 12(b)-1 fee out of your account,” says Weitz. “But chances are you have very little idea how that money is being spent. Funds should tell you how much they took, what it’s used for, and how shareholders benefited.” And yet, it’s kept secret.

7. Failure to disclose purchase/sale transaction costs
Weitz notes that “if you shopped around on the Web, you’d have no trouble buying 10,000 shares of many stocks for as little as two or three cents per share. If your fund buys 100,000 shares of stock, and it pays a higher commission of six cents per share, wouldn’t you like to know? Any inflated stock commission comes out of your pocket, and it might be a hidden payment for some type of goods or services.”

8. Failure to accurately disclose after-tax returns
Yes, funds are already required to disclose after-tax data, but it’s buried in their prospectus, thanks to the industry’s clever securities lawyers and lobbyists. In fund ads, only the few funds specifically sold as “tax efficient” must disclose after-tax data, thus cheating investors. The rest are silent.

9. Failure to disclose the effective cost of sales loads
Although the information is available from sources like Morningstar and Lipper, the average investor rarely sees it in ads or statements. There is no reason for not making full disclosure of adjusted after-tax and after-loads returns publicly in advertisements so investors can compare fund-to-fund on a level playing field—but then investors would see the reality of the lower after-tax returns, and fund managers would prefer hiding that fact.

10. Failure to disclose proxy voting
A few years ago when the SEC was considering a new regulation to expand disclosure of their proxy votes the funds argues that disclosure might hurt them, if, for example, they are also the company’s 401(k) plan manager, which is extra compensation in the fund manager’s pocket, and would expose a clear conflict of interest with the manager’s duty to investors. Clearly investors should know about obvious conflicts like this!

11. Failure to appoint truly independent directors
“Under current rules,” says Weitz, “even the former president of a fund company would be considered ‘independent’ of that fund company just two years after retirement. Former fund company executives, and outsiders who have significant ties with a fund company or its executives, should never be considered independent.”

12. Failure to disclose deals with fund trackers
“This is more of a disclosure issue from the ‘tracker’ side,” notes Weitz, for example, “T. Rowe Price has a business deal with Morningstar. I say get tough: Both should disclose this potential conflict of interest.”

13. Failure to disclose payments to preferred brokers lists
Weitz says “this disclosure would be more appropriate from the broker’s side,” making it another conflict of interest both sides should disclose.

14. Failure to disclosure how similar funds overlap
Often “several funds within a fund family own the same underlying stocks, but you’d never know this by reading any of the fund company materials,” says Weitz. “Fund companies need to highlight the fact that investors might not be properly diversified if they own certain combinations of funds.”

15. Failure to disclose red flags in SEC audits
The SEC conducts audits of some funds. But a Forbes column Neil Weinberg in noted that “the existence of SEC audits, much less problems found, is private.” The SEC submits secret “deficiency letters,” but investors never get to see these red flag warnings.

16. Failure to disclose managers “insider trading”
Fund managers are required by law to report personal trades that can “compromise fund performance,” said Weinberg . But if they do violate the law, investors can never get information from an SEC private audit.

17. Failure to disclose impact of non-asset based fees
Mercer Bullard, a former Assistant Chief Counsel in the SEC’s Division of Investment Management and founder of Fund Democracy, an investor advocacy group says that even if a fund has a super-low 0.18 expense ratio, when you add in what seems like a small $20 annual “minimum account” fee, that fee actually increases the expense ratio for a minimum $1,000 account to a “confiscatory” 2.18 percent.

18. Failure to disclose fees in dollar amounts
At the peak of the dotcom mania studies by the SEC and the General Accounting Office, Congress’s independent auditor, both “concluded that disclosing fees in dollar amounts in addition to the expense ratio in the fee table would promote price competition among mutual funds,” says Bullard. The GAO recommended quarterly. The SEC said semiannually. Nothing was done.

19. Failure to disclose brokerage costs
Bullard says “Fund brokerage (that is, commissions paid on the fund’s portfolio transactions) is not included in the expense ratio, even though, depending on what study you use, this expense can be 70 to 160 basis points and total more than the entire expense ratio.” He says you can get some of this data, but only in an obscure addendum to the prospectus and only after some sophisticated calculations. “The day this number is required to be included in the fee table will be the day that funds begin trading far less than they currently do.” And that from a former SEC insider.

20. Failure to disclose soft dollars
Funds often pay higher brokerage fees (which aren’t included in the expense ratio) and in return get back “soft dollars to cover research-related expenses, i.e., the things you would expect the manager to pay out of its management fee, not out of fund assets,” says Bullard. The fund industry’s lobbyists have prevented the SEC from requiring such disclosures.

21. Failure to honestly disclose 12(b)1 fees
According to Bullard, “many investors use the presence of a 12b-1 fee as an adverse fund-picking screen even though its presence tells you nothing about whether a particular fund is spending more on distribution than a fund that does not charge a 12b-1 fee.” In short, this practice simply adds to the confusion about soft dollars and other deceptive distribution dealings going on behind the scenes between funds and brokerage firms.

22. Failure to disclose commissions on confirmations
“Unlike confirmations of transactions in virtually all other kinds of securities, fund transaction confirmations do not have to include the commission paid to the broker,” says Bullard. “The purpose of this disclosure is to draw your attention to the economic incentive of the broker to push certain products. Inexplicably, the SEC decided to exempt funds from this requirement. This nondisclosure is aggravated when brokers are paid by the manager or by the fund through brokerage allocation.”

23. Failure to disclose taxable distributions
Check out this example: “Shareholders of the Warburg Pincus Japan Small Company Funds were shocked in August 2000 to receive a distribution of 55 percent of their accounts,” according to Bullard. “There was no announcement, and worse, most of the distribution was short-term capital gains.” The SEC should at least require “disclosing on an ongoing basis the current amount of realized gains/losses and income, so that investors at least could venture a pretty good guess as to whether a distribution lay in wait.”

 24. Failure to disclose data in a usable format
The SEC says prospectuses and other documents are filed on the SEC’s website, so some information is “available,” says Bullard. But given current online technology, this format is antiquated, loaded with legal mumbo-jumbo and totally confusing: “No one can effectively collect and analyze the data, and investors remain in the dark.”

25. Failure to disclose performance accurately
Bullard cited one fund’s late-2000 prospectus that was hyping 213 percent returns for 1999 in a barchart and table, while their current 9-month year-to-date performance in 2000 (a negative 24.8%!) was actually buried in the narrative. Unfortunately, this was a valid SEC-approved prospectus sent to investors with 22-month-old information, valid until the new one was filed in October 2001. Fund ads are similarly misleading with “stale” information.

Bottom line—trust no one, the fund investor always comes last

Over the past decades of watching Wall Street’s war against Main Street, one conclusion is painfully clear: Conflicts-of-interest are rampant throughout the Wall Street and the $10 trillion fund industry. The bottom line is very simple—the investor always comes last. Always. America’s fund managers, their powerful ICI lobby and their broadbased support thoughout Wall Street’s network have in the past and will continue in the future to fight to the death any and all efforts for more legislative and regulatory disclosure requirements, no matter how big or small.

America’s funds are managed first and foremost for the benefit of mutual fund company owners and managers, not for their investors. The $10 trillion fund industry is their cash cow, their personal piggy bank, and they are organized to protect fund owners and managers personal interests. So if you chose to gamble at their casino, you have no choice but to play by their rules—including these 25 non-disclosure protections. Just remember this simple warning: “The contest almost inevitably resolves in favor of the bottom line. Individual investors lose. Mutual fund managers win.” That warning is from an insider, David Swensen, the super-successful manager of Yale’s $15 billion endowment fund, in his classic, Unconventional Success.

One of the key principles you can never forget as an investor is very simple: All advice from anyone in the Wall Street’s “Happy Conspiracy” is self-serving, loaded with inherent legal, ethical and psychological conflicts of interest.  The insiders personal interests are protected and always come ahead of their investors interests. Always. You can never trust the “Happy Conspiracy.” Never.

FirstPubDate: Apr’04

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