Mutual fund dependency syndrome.

Mutual fund dependency syndrome.

Mutual fund dependency syndrome.

Moneybox
Commentary about business and finance.
Nov. 4 2003 4:56 PM

Our Mutual Friends

Why the scandal won't deter mutual fund investors.

New York's attorney general might shake up stocks, but not mutuals
New York's attorney general might shake up stocks, but not mutuals

The recent accusations of misdoings at mutual funds are as shocking as the 2001-02 crime spree at Global Crossing, Enron, and Tyco. The market-timing and after-market trading scandal are a Russian nesting doll of sleaze. First it was a few rogue operators allowing hedge funds to dart in and out of funds and receive preferential pricing. Then it turned out mutual fund managers at Putnam were allegedly trading in their own funds. Then it emerged that the centimillionaire CEO of Strong Capital Management may have skimmed pennies of profits that rightly belonged to long-term shareholders.

In many ways, this scandal is no surprise. For several years, mutual funds have been the great unpunished villains of wealth destruction. Many funds latched onto high-flying stocks in the late 1990s and rode them all the way down. And the same systemic problems that aggravated the stock scandals—directors and regulators asleep at the switch, greedy managers feathering their own nests at the expense of long-term shareholders, complete breakdown of compliance, governance, and ethics—are now evident at mutual funds.

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Yet the mutual fund furor presents a strange contrast. During the stock market disturbance, as soon as once-lionized CEOs were revealed to be scamps, shareholders large and small rushed for the exits. Between 1999 and 2002, according to the detailed study "Equity Ownership in America," issued jointly by the Investment Company Institute and the Securities Industry Association, the number of people holding individual stocks fell from 22.8 million to 21.5 million.

But according to ICI, the number of households owning mutual funds has steadily risen through the bust: from 44.4 million in 1998 to 51.7 million in 2000, to 54.2 million in 2002. And while managers of public employee and state pension funds have loudly withdrawn funds from Putnam and other scandal-ridden asset managers, individuals have been far more forgiving. In September, according to the latest report from Lipper, investors plowed a net $19.5 billion into stock mutual funds, pushing the year-to-date net to nearly $100 billion. The fund families accused of wrongdoing have lost only 2 percent of assets to outflows.

Even if the mutual fund scandal deepens, funds won't shed investors the way the stock market has.

The first reason mutual fund owners will remain loyal is that mutual fund assets are pretty sticky. In 2002, some $2.12 trillion in mutual fund assets were in retirement accounts—about one-third of the total. Between 1990 and 2002, mutual funds' share of the 401(k) market increased from 9 percent to about 45 percent. Retirement investors not only tend to be oriented to the long term and less itchy on the trigger, they frequently don't have much choice besidesmutual funds. Most 401(k) programs essentially offer participants the option of company stock and a smorgasbord of several mutual funds. The 401(k) nation is a captive and growing market for mutual funds.

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What's more, mutual funds will remain the entry point for people who are just starting to invest—whether it's in a self-directed retirement plan or a brokerage account. A young worker with a few thousand dollars to invest is far more likely to purchase a Fidelity or Vanguard fund than buy 100 shares of Microsoft or open an Ameritrade account.

Another reason investors will stick is that funds offer them so many choices and so many ways to spread risk. When the stock market goes bad, almost all stocks fall. But mutual fund owners can always shift to a different kind of fund. If stocks look bad, they can migrate to bond funds. If bonds weaken, how about money-market funds? There's always a putatively safe haven.

Finally, mutual funds are benefiting from good timing. The scandal struck at a moment when markets are performing well. Investors tend to be more forgiving of poor behavior when they're making money. What's more, those who hold mutual funds in taxable accounts have a powerful disincentive to redeem mutual fund shares. They may be sitting on large capital gains. An investor who hastens to send a message to Putnam by dumping shares now will trigger a late-year capital gain. She will hurt herself more than she hurts the fund.