To measure Janus Mercury's fortunes in newspaper column inches is to believe the fund is a disaster.
An aggressive growth specialist, Mercury suffered big losses in 2000 and 2001. That was followed by New York State Attorney General Eliot Spitzer singling Mercury out as an enabler of Canary Capital's market timing activities. Then, fund tracker Morningstar weighed in, urging investors to sell Mercury and avoid other Janus funds.
But for all this bad news, Mercury has been faring just fine where it matters most — in the markets. For the 12 months ending Jan. 31, 2004, Mercury returned 38.4 percent, outdoing 80 percent of its peers. Assets under management at Mercury reached $5.4 billion, well ahead of the year-ago figure and nearly triple the assets under management in 1997.
Janus is hardly alone in damning the headlines. Though scandals have dominated the news, the funds themselves have delivered strong results. In fact, by many measures, 2003 ranked as one of the best years ever for the fund industry. The average domestic equity fund returned 30.7 percent, more than 2 percentage points ahead of the Standard & Poor's 500 stock index.
Make no mistake: These scandals are not insignificant events. Some fund executives betrayed the trust of shareholders and should be punished (and have been: Janus and other offending fund families have suffered billions of dollars of redemptions by angry investors). But the great majority of companies have been run responsibly, and continue to be so. Shareholders seem to understand this and continue to embrace funds. Net sales of stock and bond funds totaled $217 billion in 2003, according to the Investment Company Institute (ICI), the mutual fund trade group. And with the stock market rising, assets at funds increased by more than a trillion dollars to $7.4 trillion, the highest annual gain ever.
“People are sticking with mutual funds,” says Joel Weiner, a registered rep with National Planning Corp. in Allentown, Pa. “Mutual funds are still the best vehicle for many retail investors.”
One of the big complaints, of course, are the costs that retail fund investors shoulder. For instance, a study by John Freeman of the University of South Carolina and Stewart Brown of Florida State University showed that institutional investors typically pay lower expense ratios than retail investors do. Spitzer maintains that an individual investor should pay the same expenses as an institutional one.
From the ICI's point of view, though, such an assertion is absurd. Overseeing thousands of individual accounts costs significantly more than servicing one giant institution, it argues, so the expense discrepancy makes perfect sense. Nonetheless, Spitzer continues to push for fee reductions in his scandal-related settlements with Alliance Capital and Putnam Investments.
Will retail fund costs come down industrywide? Probably. But here's the interesting thing: Market forces, rather than regulatory pressure, are likely to be the primary driver of such change. Already the influx of investor assets is resulting in some efficiency gains that the industry is passing along to retail investors.
To hear some tell it, though, funds are systematically bilking retail investors. Vanguard founder John Bogle and other fee critics note that according to Morningstar the average domestic equity fund has an annual expense ratio of 1.50 percent. By some calculations, that is higher than in the past, when the fund industry had fewer assets. Thus, they argue, funds are not passing along economies of scale to investors.
But the 1.50 percent figure is misleading, says Avi Nachmany, president of Strategic Insight, a fund tracker, because people tend to compute the expense ratio wrong by using a simple arithmetic average. What is needed is an asset-weighted average, Nachmany says.
“The use of simple mathematical averages, which equate the fee ratios of the many thousands of tiny expensive funds that hardly anyone owns, with the few hundred that most shareholders use, is inappropriate, misleading and irresponsible,” Nachmany says.
Take Fidelity's Magellan fund, which oversees $70 billion in assets for 5 million shareholders, for example. It has an expense ratio of 0.72 percent. Compare that to Boyle Marathon, which has $1 million in assets, 400 shareholders and an expense ratio of 3.0 percent. Taken together, the two funds have an average expense ratio of 1.86 percent, a number hardly representative of what most investors in the two funds experience.
“When the critics look only at the simple average of expense ratios, they are committing a statistical lie,” says Nachmany.
Because of the way economies of scale affect expenses, it is not surprising that many of the fee-related issues revolve around small funds. According to Morningstar, domestic equity funds with less than $50 million in assets have an average expense ratio of 1.66 percent. But that figure drops with size. Investors shoulder fees of 1.32 percent in funds with less than $100 million, and 1 percent for funds with more than $1 billion. Portfolios with more than $10 billion charge only 0.66 percent.
For those worried about investors overpaying, the efficiency of big funds should be welcome news. Lately many big funds have been top performers, and investors have been gravitating to them. The list of top-selling families in 2003 included low-fee powerhouses, such as Fidelity Investments, Dodge & Cox and T. Rowe Price. The scandals also have played a role in lowering fees. Some high-fee funds committed misdeeds, frightening away investors who have fled to low-fee choices with cleaner records.
“The marketplace is taking care of most problems about high fees,” says Sheldon Jacobs, editor of The No-Load Fund Investor, a newsletter in Ardsley, N.Y. “There's no reason for Spitzer or the SEC to say what fees should be charged.”
Along with focusing on fees, some press accounts about the scandals have predicted investors would flee actively managed funds in favor of indexers or exchange-traded funds, which have low fees and cannot be manipulated by market-timers. But the exodus to passive choices has not happened. Indexers continue to hold less than 10 percent of all fund assets, and there is no sign that they are growing rapidly.
The top-selling fund family in 2003 was American Funds, which had net inflows of $65 billion, the company's best year ever. American is an unlikely choice for do-it-yourself indexers. A load seller, the company has long enjoyed a reputation for top-performing active management.
Why do so many people continue to avoid indexing? “People want advice,” says Nachmany. “They don't like the feeling of being on a ship where there is no captain.”
Off the Mat
Despite the gains in these funds last year, not all portfolios emerged from the market turbulence and scandals unscathed. Aggressive growth funds suffered a particularly heavy toll. Because they are so volatile, aggressive funds make natural targets for market-timing speculators. And with growth funds starved for assets during the downturn, executives were willing to strike deals that later proved embarrassing.
The list of scandal-plagued fund families reads like a who's who of 1990s growth stars: PBHG, Invesco, Fred Alger and Putnam. Those funds are now locked in a struggle to win back credibility. The task is all the more difficult because many of the companies are suffering withdrawals, which place downward pressure on prices of portfolio holdings at a time when the managers are hoping to look their best.
Funds are trying a variety of strategies to recover. Some battered funds are toning down risk levels. “We are seeing some funds that are trying hard to avoid any big blowups,” says Dan McNeela, a Morningstar analyst.
McNeela cites Janus Enterprise, a formerly aggressive fund that has taken a tamer approach. Instead of holding big positions in technology names, Enterprise is staying more broadly diversified, holding some industrials. Putnam Opportunities is another hard-charging choice that is slowing a bit. “Putnam has a new team in place that seems determined to stick closer to the benchmark and avoid big positions in technology,” McNeela says.
Still, some true growth choices still have clean records. McNeela recommends Fidelity Capital Appreciation and Vanguard Growth Equity. And not all aggressive funds have toned down their acts. PBHG Large Cap Growth, an aggressive choice, still holds some of the same stocks it owned in 1999. The fund became embroiled in the scandals, but the current manager, Michael Sutton, vows to maintain the approach that has helped the fund score huge gains in bull markets. Despite taking a big hit in the downturn, PBHG Large Cap sports a decent long-term record, returning 2.1 percent annually over the last five years, 3 percentage points ahead of the S&P. For people with strong stomachs, the fund could make an intriguing holding.
A big challenge for PBHG and other aggressive funds now is to educate shareholders about how to use a volatile fund. Too often investors come aboard at the top of the cycle. When the downturn comes, the volatile choices crash and shareholders flee. Instead, the time to buy the funds is when they are out of favor.
Funds like PBHG must now reassure investors, and put the scandals behind them. That may not take much time. McNeela estimates the investigations will wrap up within a year. Then investors can be assured that wrongdoers have been caught and the industry is clean.
This is good news, of course. If the industry is faring well even before reforms take hold, imagine how it will look afterward.
2003 was a record year for mutual funds, despite the troubles.
|Net Mutual Fund Assets (billions)|
|Type of Fund||Dec. 2003||Dec. 2002|
|Taxable Money Market||1,764.30||1,997.20|
|Tax-Free Money Market||288.4||274.8|