Mutual Funds: Legal Probes Threaten Profits

Oct. 30, 2003 -- Many mutual fund firms are enjoying strongquarterly earnings, thanks to growing investor optimism and arebounding economy. But a widening regulators' probe into shadytrading practices threatens to cut into fund firms' profits.

Massachusetts and federal regulators filed civil complaintsTuesday against Putnam Investments for allegedly improper activity.It was the first formal accusation of wrongdoing against a mutualfund company.

That comes after New York Attorney General Eliot Spitzer accusedhedge fund Canary Capital Partners LLC in September of illegaltrading involving Bank of America Corp., Janus Capital Group Inc.,Bank One Corp. and Strong Financial Corp. funds.

And several other companies, including Merrill Lynch & Co.,Alliance Capital Management Holding LP, Prudential Securities andFred Alger Management, in recent weeks have suspended or firedemployees believed to have engaged in illegal trading.

But while some fund shares have taken a hit on the news, theoverall stock market recovery has driven up mutual fund assets,leading to higher revenues and profits. Analysts say the probe'sfindings so far might have come too late for third-quarter earningsand the impact could be felt later.

"The probe could affect every single company in the industry,"said Rachel Barnard, a stock analyst at Morningstar Inc. whofollows asset managers. "There certainly could be more revelationswhich have to make investors cautious."

Still, analysts believe the probe shouldn't dramatically hurtfund firms' earnings so long as the price tag of the scandalremains in the millions. That figure would be just a fraction ofthe $7 trillion total in industry assets.

Spitzer's complaint alleges illegal late trading, which StanfordUniversity professor Eric Zitzewitz has estimated costs investorsabout $400 million a year. It also includes allegations of markettiming, a practice that is illegal only to the extent fundprospectuses prohibit it; that activity is estimated to costlong-term investors billions of dollars.

So far, Bank of America and Bank One have pledged to payrestitution to harmed investors, but have not provided estimates onhow much that will cost. Separately, Bank of America set aside $100million to cover legal and consulting costs.

Meanwhile, the two banks reported better-than-expected profits,citing in part substantial stock market gains. Strong is aprivately held company, and Janus was set to report earningsWednesday.

"The cost will amount to how many millions this adds up to,divided by the number of fund holders and funds," Barnard said.Given that there are hundreds of fund firms and millions ofinvestors, "anybody's restitutions will be pretty small andoverall company liability will be pretty small," she said.

Mark Morgan, an equity analyst at Standard & Poor's Corp. whocovers large banks, agreed. He doesn't expect Bank of America orBank One to suffer greatly because their banking and otherbusinesses can cushion losses from their mutual fund units.

In addition, the banks rely more on relationships between abroker and client to maintain its mutual fund business than a fundfirm like Janus, which allows investors to trade directly online.Thus, Janus customers might be more prone to flee their accountssince they don't have brokers who could try and allay theirconcerns.

The probe "is not a deal breaker in terms of whether I buy orsell (bank) stocks," Morgan said. "It's more of a reputationalissue than a financial impact. … Bank of America handled it wellin terms of coming forward and making restitutions. It does takesome money out of their pocket but it avoids a lot of problems inthe future."

Indeed, the four fund firms named in the Spitzer complaint hadinvestor outflows in September totaling $7.9 billion, or about 1.85percent of their total assets, according to Lipper Inc. More thanhalf of that amount, or $4.4 billion, came out of Janus funds.

That has led UBS Securities and other firms to lower Janus'earnings outlook for 2004, citing the increased risk of outflows inthe near future.

Other fund firms, however, might represent good bargains, saidBarnard, who likes the long-term outlook for companies such asAlliance Capital.

"It could be a good time to pick good companies on the cheap,"she said. "The stock prices took a hit when revelations came out,but if you think long term over three to five years, this probablywon't have a huge effect."