When It Comes to Fund Industry, Public Trust Must Be a Mutual Issue

The mutual fund industry’s long honeymoon with the media may be over. At issue is whether the press--and, more important, the public--can continue to trust the industry’s ability to vigorously police itself.

This is more than an academic question: The $2-trillion fund industry has been built up largely on investors’ trust over the last 10 years. The fund business is, arguably, the cleanest $2-trillion business in the nation and perhaps the world.

But with the phenomenal growth in fund assets, especially since 1990, the potential for scandal, self-dealing and irresponsible marketing has mushroomed. Two developments point up the fund industry’s new vulnerability:

* Last week, Denver-based fund giant Invesco fired a star portfolio manager for allegedly failing to follow the firm’s rules on reporting personal securities trades.

The firing has raised questions--and generated a host of news stories--about the adequacy of controls over the ballooning ranks of fund managers who have been entrusted with the public’s money.

* On Thursday, state securities regulators, the American Assn. of Retired Persons and the Consumer Federation of America will jointly release a public poll showing that many people who are buying investments through banks have no clue about the risk involved. The poll results will directly indict bank sales of mutual funds, which have rocketed since 1990.

This latest investor survey will almost certainly add momentum to federal regulators’ campaign to change the investment sales practices of banks. Indeed, a similar survey done for the Securities and Exchange Commission in November showed 41% of investors who bought mutual funds through a bank believed that the funds were backed by the bank’s assets. (They aren’t.)

Is this a fund industry problem? Many fund executives say it isn’t; they blame the banks. But that is being extremely shortsighted. In both examples here--the internal-controls issue and the problem of a confused public--it’s time for the fund industry to do what it has historically done very well: police itself intensively. Here’s why.

* The public needs to feel sure that it is getting a square deal from fund managers. Americans have turned to funds in huge numbers largely because they believe they can’t compete in financial markets on their own. There is a deep distrust of Wall Street, big-time traders and brokers.

If investors begin to doubt that fund managers are much different from the market crooks who paraded through federal courts in the 1980s--people whose main goal was to enrich themselves, to others’ detriment--the fund industry will lose one of its most important selling points with the small investor.

In firing fund manager John Kaweske, Invesco alleged only technical violations of company rules on personal securities trades. But in the aftermath of that firing, the media has begun to ask many questions about what fund managers are allowed to do with their personal money and whether they can profit at the expense of their fund shareholders--by trading in their own accounts ahead of trades they make for their funds.

For the most part, the big fund companies have insisted--convincingly--that they would never allow such “front running” and that they have the internal controls in place to make sure it doesn’t happen. “Our rule is simple: You don’t do it,” says Jon Fossel, head of fund company Oppenheimer Management in New York.

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But some fund industry executives say the bigger issue is whether fund managers should be allowed to trade privately in individual stocks, period. Front-running is obviously illegal, but there are many more gray areas that arise when a manager can own a stock personally and potentially influence it with fund money, or discuss it with other fund managers in the same company who could influence it.

John Rogers, head of fund company Ariel Capital Management in Chicago, says he simply doesn’t trade in individual stocks himself. “I feel that I should have my money in my own fund,” he says. “If I’m selling my shareholders on the idea of diversification, I think I should follow that advice.”

Whether that extreme a policy is necessary--or beneficial in the long run--is a matter of great debate, however. Telling star managers to stop trading the market personally is asking them to stop doing what they’re paid to be very good at.

“I don’t have a problem with permitting” personal trading, says Michael Lipper, head of fund tracker Lipper Analytical in New York. “The problem I have is, how (well) do you police it?”

What is important now is for the industry to take a close look at how it monitors its managers and whether tighter rules, or tighter enforcement, are needed. And the rules should be communicated directly to investors by the funds.

* If fund buyers don’t understand what they own, the industry is sitting on a time bomb. The SEC-commissioned investor survey last fall, and the survey due out Thursday from the state securities regulators and the AARP, both show that a substantial number of new fund investors don’t grasp a simple concept: Mutual funds aren’t insured by the government or a bank. Owning them entails risk of loss if the market goes against you. And nothing about bank-sold mutual funds makes them any safer than other funds.

Whose fault is it that people don’t understand basic market risk? It’s easy to blame the banks, who now make 15% of all fund sales. Obviously, many conservative savers are walking over to in-bank securities salespeople and asking for something that offers higher returns than meager 3% CD yields. The salespeople are merely obliging their customers, and the fund companies are only too happy to let the banks sell their products.

Fund executives concede--often unapolo- getically--that they can’t make sure that every conversation between a bank salesperson and a new investor includes the necessary caveats about risk. “At the sales desk, there’s nothing more we can do to police this, other than with the fund literature itself,” says Oppenheimer’s Fossel.

*

Well, maybe and maybe not. Many fund companies’ literature--the jacket to a prospectus, for example--certainly could be made more dramatic in warning of risk. (How about big red letters on a black background, stating “THIS INVESTMENT IS NOT INSURED”?)

Second, the funds could demand that bank clients follow some simple rules that many now don’t: For example, demand that an in-bank salesperson get the customer’s signature on a form that states explicitly that the customer understands the risks in owning a fund. (California banks are ahead of the curve on this: A recent poll by the California Bankers Assn. found that more than 90% of CBA member banks get such signed statements.)

Is this expecting too much of the funds? Are they being asked to protect the public from itself?

Perhaps. But in the long run, the industry ought to realize that if the public fails to grasp the unavoidable risks it is taking via the funds, the accusations, anguish and lawsuits that will fly in the next stock and bond bear markets--and the outflow of money from the funds--will be as unprecedented as the current flow of money into the funds.

The Funds’ Achilles Heel?

In a November survey of investors who purchased mutual funds through their bank, the level of misunderstanding about fund investments was shockingly high. An example:

“Are mutual funds sold by a bank backed by the bank’s assets?” (Percentage of investors responding:) Yes: 41% No: 40% Don’t know: 19%

Source: Market Facts

Confused Investors

How a sampling of investors who have purchased mutual funds through banks responded to a series of questions in a fall survey prepared for the Securities and Exchange Commission:

Bank fund buyers’ response: Survey statement Yes No Unsure Mutual funds bought 49% 40% 12% through a stockbroker are federally insured. You can lose money 84 10 6 in a money market mutual fund. All funds sold through 30 60 10 banks are federally insured like CDs. Funds sold through 37 56 8 banks are safer than other mutual funds.

Note: Totals may not add up to 100% because of rounding.

Source: Market Facts (survey of 1,000 households)