Ten years ago this month, the mutual fund industry was knocked off its lofty perch when a series of scandals tarnished the reputation that the industry had been proudly building for more than 70 years.
Since then, the industry has been in a near-constant state of image repair, along with some denial.
It began in the fall of 2003 with a complaint by New York Attorney General Eliot L. Spitzer charging Bank of America Corp.'s Nations Funds with allowing a hedge fund company to “late trade.” It spread rapidly, ultimately becoming a major black eye for an industry that had long touted its ability to cater to individual investors.
The initial fallout, which implicated more than a dozen firms for various acts of front running, market timing and insider trading, was swift and, in some cases, severe.
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Richard Strong was banished from the industry, and the fund company he founded, Strong Capital Management Inc., wound up being absorbed by Wells Fargo after it was discovered that some Strong funds allowed market-timing trading for preferred clients.
Lawrence Lasser resigned as chief executive of Putnam Investments LLC after the company was implicated in allowing some investors to trade funds after hours.
Once the initial sparks were set, the Securities and Exchange Commission kept piling on the lumber, with charges, enforcement proceedings and fines against such household names as Alliance Capital Management LP, Columbia Management Advisors Inc., Edward D. Jones & Co. Inc., The Goldman Sachs Group Inc., Invesco Funds Group Inc., Janus Capital Group Inc., Marsh & McLennan Cos. Inc., Morgan Stanley & Co. LLC, Prudential Securities and Wachovia Corp.
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“My God, it had such a huge impact,” said Steve Graziano, president of Touchstone Investments. “At the time, it made a lot of big headlines, so the public was alerted and their sensitivity was heightened.”
Today, most of the $15 trillion mutual fund industry would rather not discuss or even acknowledge how so many companies that had built such solid brand names by developing products aimed at individual investors could have so shamelessly breached that trust.
“I think the impact was profound because this was an industry that always viewed itself as wearing the white hat,” said Don Phillips, president of fund research at Morningstar Inc.
“For decades, the fund industry was lavished with praise, and mutual funds were viewed in a very positive light for the idea of bringing great portfolio managers to individual investors,” he said. “But the scandals changed that view for a lot of people.”
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Advisers felt duped
There is plenty of debate over exactly how closely most retail investors followed or understood the details of the fund industry scandals, but sentiment naturally becomes more intense when it involves financial advisers, many of whom still feel duped by the fund industry.
“That is what caused us to stop using mutual funds and go into exchange-traded funds,” said Theodore Feight, owner of Creative Financial Design.
“I'd like to think the fund industry has changed since 2003, but I don't know if it has, and I know my clients never got the money back that they lost as a result of what the fund companies were doing,” he said. “I don't think I could say with certainty that fund companies would never, ever again let some clients trade after hours like they did, and that's sad.”
Across the financial advice industry, the fund scandals of 2003 are now viewed from a range of perspectives, including some, such as Mr. Feight, who have since sworn off mutual funds as a result, and others who argue that the scandals were sensationalized by overzealous and polarizing politicians.
“When the scandals broke, they made sensational headlines, but in the end, the problems that were uncovered barely amounted to a rounding error, and it's barely a footnote anymore,” said Paul Schatz, president of Heritage Capital LLC.
He contends that most of the fund industry wasn't providing illegal or unethical preferential treatment to investors, and for that reason, he doesn't think that any of the regulatory efforts that have resulted will have much of an impact on the industry.
SEC initiatives
Within five months after Nations Funds was cited for late-trading practices, opening the floodgates to a raft of reports of related fund industry wrongdoing, the SEC had introduced at least a dozen initiatives aimed at policing what appeared to be rampant problems.
The initiatives generally strived for greater transparency, along with more internal and external oversight of portfolio management, and fund company operations and distribution.
“There is a positive regulatory legacy and maybe a sense of humility that reminds us to pay better attention day by day,” said Paul Schott Stevens, president and chief executive of the Investment Company Institute.
Asked if he thinks enough safeguards are now in place to prevent a repeat of the 2003 fund industry wrongdoings, he said, “I believe yes.”
Some proof of that is illustrated in the way the fund industry weathered the 2008 financial crisis, Mr. Stevens said.
“We went through what people legitimately call the worst financial crisis in generations, and we've seen massive changes in laws that affected virtually everyone except registered investment companies,” he said. “I think the mutual fund industry came through that crisis with its reputation intact.”
Whatever the fund industry's reputation these days, it would be difficult to dispute the increased scrutiny, particularly from inside most of the companies.
“Our organization was started as a result of the 2003 events,” said Susan Ferris Wyderko, president and chief executive of the Mutual Fund Directors Forum, an organization dedicated to improving the efforts and abilities of independent mutual fund board directors.
“The SEC in 2003 looked around and realized that there wasn't much out there for fund directors, so the forum was founded at the behest of the SEC,” said Ms. Wyderko, who joined the forum in 2006 from the commission, where she had been director of the Office of Investor Education and Assistance.
“I have seen an evolution from the point of view of a regulator, and there has really been a sea change in the culture of the independent board meeting,” she said. “It used to be that many of the board meetings were organized around a relatively short meeting and a relatively long golf game.”
'Actively in the dark'
In the past, fund boards “were kept actively in the dark and not told about these [market-timing, front-running and late-trading] arrangements,” Ms. Wyderko said.
Through efforts led by membership organizations such as the forum, she said board meetings have become “extremely professional.”
“We have watched the professionalism evolve across the fund industry,” Ms. Wyderko said. “Not to say that it wasn't professional before, but those individuals who weren't interested in upping their game have left the fund industry.”
Contributing to the increased level of professionalism is the proliferation of chief compliance officers inside fund companies.
“We know the SEC's inspection process is minimal, so the chief compliance officer's self-inspection is the primary oversight,” said Geoff Bobroff, a mutual fund industry consultant.
Prior to 2003, most chief compliance officers inside fund companies lacked sufficient power to adequately oversee companies even from the inside, said Jeff Tjornehoj, head of Americas research for Lipper Inc.
“My impression was that compliance officers hadn't been given a lot of authority inside fund shops until after [2003] when the CEOs decided the CCOs needed autonomy,” he said. “I'm sure there are more firewalls within firms that were created by chief compliance officers.”
Of course, any kudos offered to the fund industry for stepping up its internal compliance efforts should be considered in the context of an industry that in many respects put those risks on the back burner until it was too late.
For example, the so-called time zone arbitrage trading that allowed some investors to trade mutual funds in one time zone based on as-yet-recorded prices that had closed in a different time zone wasn't a secret to most of the industry prior to 2003.
“The specific issue that was at the heart of ... this was around time zone arbitrage that some investors were taking advantage of, which we talked about a number of times prior to 2003,” said Avi Nachmany, director of research at Strategic Insight.
Early efforts
Mr. Stevens, who took over as head of the ICI in June 2004, said the organization made proposals as early as the mid-1990s for increased compliance efforts in the fund industry.
“From time to time, there had been suggestions that funds be put under a [self-regulatory organization],” he said. “The institute and our members never thought that was a good idea, but one suggestion we made in the "90s was to prescribe specific structures that we could apply ourselves.”
That is essentially where the industry is now. And considering the limitations of the full-time regulators, who are often a step behind the evolutionary pace of the financial services industry, that might be all anyone can expect.
“I think the risk is always there for another scandal, but there are reasons to believe that the industry is more on guard now,” Mr. Phillips said.
“Having gone from wearing the white hat in the 1990s to being described by some as a cesspool after the scandals will help to mitigate the chances of the same thing happening again. But there are always going to be bad guys out there looking for an advantage,” he said. “The reality is, the fund industry was never as good as it was viewed in the "90s, and it was never as bad as people like Eliot Spitzer painted it to be.”
