November 18, 2003
Donaldson’s Disgrace In The Name of ‘Restoring Investor Confidence’
By Brady Willett
As the great mutual fund scandal continues to grow some are saying to dump scandal ridden funds while others argue don’t panic. Who is saying never buy mutual funds?
Former SEC boss Harvey Pitt walked in the shadows so as not to be seen dining with the enemy. However, it is unlikely that even Pitt would attempt to reconcile today’s mutual fund scandals with civil charges, no admission of guilt, and toothless remedial actions. Rather, when listening to Pitt’s SEC broadcasts you got the feeling that the man had a backbone; that while he was recklessly loyal to his buddies he could also turn on them if they threatened to make him look like a fool. Apparently, William Donaldson has no such backbone.
Why are some investors as upset as Spitzer about the SEC’s quick agreement with Putnam? Well, unlike the Wall Street Settlement – where proving wrong doing might have been left to juries deciphering emails – making a case stick against Putnam seemed easy.
Q: Did you make these illegal trades - the same trades you admitted making and that we have records for?
A: Yes.
Verdict: Guilty.
Nevertheless, Donaldson – no doubt overly concerned with the potential fallout in the markets - was comfortable letting Putnam off the hook. He was also comfortable accepting a check from Morgan Stanley yesterday for $50 million relating to their illegal mutual fund dealings…again, no admission of guilt.
After realizing that Donaldson doesn’t care about investor interests, the fund fraudsters’ are coming out of the woodwork to receive their slap on the wrist: recently Charles Schwab and Alliance Capital Management Holding detailed abuses in their fund operations, and Bear Stearns fired four brokers and two assistants because of mutual fund trading activities yesterday.
Is Donaldson beginning to look like a fool? More on this in a moment…
Why Mutual Funds?
I have never understood the logic behind buying mutual funds. To be sure, if an investor has time to sort through a mutual fund prospectus (a document, according to the SEC, that most fund players do not even read), then it doesn’t take a giant leap of intelligence to start reading company filings. Moreover, it is mind numbing the amount of energy I have seen friends and family waste wondering if they should raise their 5% ‘International Equities Fund’ position to 10%. Why? Because when it is all said and done none of these individuals have a clue about which companies, or even which countries, they are invested in.
As you may have guessed, I carry a great deal of impatience when it comes to understanding the average mutual fund investor. Moreover, it goes without saying, that I also despise the mutual fund industry. However, my feelings about mutual funds have nothing to do with the fact that funds like to engage in skimming. Rather, I am not attracted to the mutual funds because most funds underperform the S&P 500, many carry complex and excessive fee/tax structures, and most mutual fund owners are silent partners. Lastly, and most importantly, owning a mutual fund limits your investment options.
Index Funds The Better Bet
You are believer in technology stocks and have been brainwashed into believing that buying individual companies is more risky than purchasing mutual funds. What do you do?
Well, instead of sorting through the endless supply of tech funds, you could simply purchase the Nas-100 (QQQ) or the S&P technology sector (XLK) to acquire exposure to the industry. The benefits of these funds compared to your typical mutual fund are readily apparent: both of these index funds have lower fees and the stocks the fund owns, and will continue to own, are known before you buy.
These advantages aside, the most important reason to favor index funds is that many are optionable. What this means - to the long-term fund owner - is that when the price of the stock (these index funds trade like stocks) escalate to levels which make your hair stand on end, you can write covered calls as opposed to scrambling to sell. Given that volatility is what determines option premiums, if you write calls at opportune times you can earn a nice return.
Not being a fan of technology stocks, I am by no means recommending the above investment approach. Furthermore, I am not saying that you should use covered calls unless you fully understand the pros and cons of such instruments. However, the logic of maximizing returns remains – index funds (or ETFs) generally serve the same purpose as mutual funds, and they are better investment instruments.
Scam or Legitimate Business?
When Wall Street passes out their ‘how to make money in the market’ brochures, they do so with the understanding that the investing public are sheep. Wall Street didn’t come to this conclusion over night. Rather, it took many years of customers wanting to buy faceless ‘International Funds’ for the Street to understand that the public will happily buy anything…
With this in mind, in order to promote managed mutual funds (instead of say DRPs) firms have to sell the wisdom of mutual fund investing. This practice loosely entails explaining the advantages of diversification and asset allocation, but primarily deals with telling the investor about exposure and risk. The logic being that if you want to be exposed to fantastic gains you have to take some risk…
Failing to attract more money with these tactics, Wall Street focuses on the allure of past returns. Specifically, and lauded in interviews on CNBC and countless books, Street salesman point to the historical returns of fund hero’s like Templeton and Roberston. Apparently the mere existence of a handful of legends makes the thousands of funds in existence today more attractive.
Suffice it to say, given that the Street promotes and runs funds with a ‘do as I say not as I do’ attitude, concluding that funds are legitimate and worthy investments is difficult to do. After all, when the Street isn’t trying to sell stuff to the public they spend a great deal of time making money in derivatives, and flipping stocks in the short term instead of the ‘long-term’.
In short, for these and other reasons, mutual funds are a Wall Street scam -- they always have been and always will be. That Donaldson is unprepared to attack the industry means that he is in on this scam.
Donaldson Is Like All The Rest
Feeling the pressure after the Putnam debacle, Donaldson said yesterday that the SEC plans to step up regulation of mutual funds. This comment becomes more moronic the longer you think about it. After all, the SEC just elected to loosen its grip on the fund industry by quickly settling with Putnam and others.
What Donaldson and many other SEC bosses before him fail to realize is that investors want easy to understand corporate disclosure. Failing this, they want criminals to be held accountable for their actions. What investors do not want is for the SEC to collect token amounts of money from criminals and say that everything has been fixed.
Why does the SEC constantly fail? Because the mandate of the SEC is no longer to police and set standards, but to work tirelessly to ‘restore investor confidence’. This phrase – harmless as it sounds – should not be in the SEC’s vocabulary. Rather, the SEC should force companies and mutual funds to disclose their business practices in the most lucid manner possible – if investors are confident or terrified with the truth so be it.
As for Spitzer – who it is difficult not to be a fan of - we should nonetheless not forget that when the chips were down he folded his hand and settled with The Street. Accordingly, rather than Spitzer, the only man for the job of SEC boss is Warren Buffett. Buffett quickly rebukes the exposure/risk argument with one statement: “risk comes from not knowing what you are doing”.
Incidentally, the SEC was not always a toothless collection of accountants and insiders. Rather, when the SEC was formed in 1933 change was in the air, and accountants and companies were terrified:
“The risk assumed by an accountant-officer or by a professional accountant, who signs the registration statement submitted to the Securities Commission of the Federal Trade Commission, is quite out of proportion to the possible material benefits that may be derived from the service rendered.”
Robert Weidenhammer, University of Minnesota, Jan 1933. The Accounting Review.
70-years later, accountants, insiders, and Wall Street – powerful beyond their wildest dreams - are dealing in the shadows…knowing full well that their campaign donations will ensure that a Donaldson or Pitt is always in charge of policing their shady, profitable dealings.
Getting back to the question at hand, is Donaldson being made to look like a fool? Well, because Pitt was allowed 3-strikes and Donaldson has only registered one the verdict may be uncertain. That said, it is certainly the case that if Donaldson believes that ‘investor confidence’ needs to be restored today that he is out of touch with reality.
BWillett@fallstreet.com
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