The Heart Of The Matter

The most disconcerting aspect of the unfolding mutual fund scandal is that when you talk to people in the fund business, many will tell you privately that we‚ve only seen the tip of the iceberg. Whether or not they are correct or simply traumatized by the rash of recent revelations remains to be seen.

Even if the scandal fails to mushroom into something larger (like incidents of managers purchasing stocks for their portfolios and front-running fund shareholders), a lot of damage has already been done. And as so many commentators have noted, so far the least of the damages are financial.

But that‚s exactly the point–and the problem. Many of America‚s 90 million or so mutual fund investors had their pockets picked for a few bucks by people who were earning seven-figure salaries (in one case, the perpetrator was an ex-billionaire).

The financial damage may have been miniscule (remember the folks who couldn‚t find any victims of Ivan Boesky‚s insider trading), but the violation of advisors‚ and investors‚ trust is going to take a long time to heal. And I know many advisors who are asking themselves, if fund companies did this to us, what else might they do to clip clients?

One of my favorite advisors, Bill Bengen of El Cajon, Calif., noted a few months ago that the fund business for decades has stood apart as a shining beacon of light undimmed by all the scandals so endemic on Wall Street. Some folks, like Investment Company Institute President Matt (Stonewall) Fink, wanted us to believe that there was something inherent in the structure of the Investment Company Act and intrinsic to the character of fund executives that explained all this. Of course, Matt.

Not surprisingly, there are calls in some quarters for advisors to abandon mutual funds, or at least reduce their reliance on them. Even before the scandal surfaced, sophisticated advisors and clients were actively exploring alternatives like separate accounts, hedge funds and self-managing their own portfolios. No doubt, this will encourage them to continue to look elsewhere.

But for millions of Americans, hedge funds and separate accounts are either out of reach or, in the case of individual stock portfolios, unwise and impractical. Funds remain the best way for most investors to purchase a diversified portfolio.

At some level, market forces will punish the perpetrators, even if regulators don‚t. Fund companies who crossed the line are already experiencing an exodus in assets at a time when total inflows into funds are gaining momentum. No doubt index funds and ETFs will be beneficiaries, and active managers will suffer. Sadly, this phenomenon will take place in a low-return era when active management may actually make more sense.

As always, one can find some degree of comic relief to the whole sordid scandal. Like the boilermaker in Queens, N.Y., who earned a much higher return flipping his Putnam funds after hours than some brainiac Stanford University professor could achieve.

And there are other lessons, too. At this year‚s Financial Planning Association (FPA) and Schwab Institutional conference, many advisors were talking about reallocating client assets to funds where the managers are the largest shareholders. It‚s hard to imagine that people would want to sandbag themselves, but at this point, I wouldn‚t even rule that out.