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Plea bargain time: how US managers rort investors

By Neville Bennett

Friday 22nd August 2003

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Funds are in the gun in New Zealand (NBR, Aug 15) and elsewhere. In the US they are being investigated by two redoubtable groups and can expect some fierce retribution if the crimes they are accused of are established. I expect a flurry of plea bargaining in the established American style.

Last month, an influential Congressional committee sent a bill to the House that would compel funds to disclose information on such matters as expenses, trading costs and incentive deals with brokers.

Meanwhile, the respected (and dreaded) US Securities & Exchanges Commission is investigating manager compensation and fee disclosure.

So what is wrong with the funds? Many are accused of deception and secret practices that disadvantage their shareholders. Some charges include:

* Hidden costs: Although the funds declare an annual expense ratio, there are hidden costs that are extracted from returns. These include brokerage commissions on stock trades, and these amount to 11c for a buy and sell per share. But this is a spread charge, the difference between a stock's bid and ask price. This amounts to about 2% on trades. Some managers are volatile traders, and brokerage can be a large hidden cost, especially as the average fund has a 110 % turnover ­ that is, a manager sells his entire portfolio in a year. Total hidden costs average about 3% a year, according to the founder of the Vanguard group.

* "Soft dollars": It is standard industry practice to over-pay brokers and others for their services to a fund. This is legal. The manager/company gets the difference in backhanders. These are rarely in cash and are supposed to be in the form of advice but common backhanders are subscriptions (golf clubs?), telephones and computer gear ­ perhaps a Reuters terminal. Some of the murkier examples include professional development fees for business schools, even membership of exclusive clubs. Equipment is often provided. A firm might want $10 million worth of equipment and does a deal to get it by offering a brokerage of $16 million in commissions. That deal is very profitable, for if the company bought the equipment it would be an operating expense; if it comes through brokerage it can be charged to fund shareholders. About $10 billion in "soft dollars" are traded each year.

* Manager's bonuses: These can be almost a half of a manager's compensation. Sometimes they are awarded on the performance of a fund over a quarter. More usually it is over a year. The bonus can cause managers to take great risks. It is almost impossible for shareholders to find out the basis on which bonuses are paid but it can affect fund performance. Sometimes a company has several funds and each fund buys lots of a favoured stock. The stock increases in price and the managers get their bonus. This does not help the shareholder in the longer term.

* Overlap: There is considerable overlap in families of funds but funds often resemble others. For example, you might buy Magellan and Spartan 500 for your retirement savings but 68% of their stocks are duplicated. This duplication reflects the fear of managers that they might stand out from the group. Better to do what everyone else is, then you cannot be blamed if something goes wrong. There is, incidentally a web-based tool, called Overlap, which looks for mimicry.

* Tax: Funds do not really disclose their trading policy, which can have considerable implications for taxpayers.

* Overstretch: During a year the average manager buys into 160 holdings. It is impossible for a mortal to really know 160 companies. Nor is there much incentive to study them thoroughly, as many will be soon turned over.

* Role of analysts: Analysts, often in-house, advise a manager what to acquire. This reduces a manager's knowledge of a stock.

* Wall Street research: The big firms push certain stocks and encourage managers to trade. Enron was a "buy" even as it imploded. Florida's public pension succumbed to this "strong buy."

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