LASERS Asset Allocation Follow Up

1
A Consultants Perspective on the Mutual Fund
Scandals
Jay E. Roney, CTP Senior Consultant
Dick Charlton Chairman and CEO
March 24, 2005
One Main Street, Cambridge, Massachusetts
02142 TEL [phone] FAX (617)
374-1313 www.nepc.com
2
Introduction

• In a December 2003 letter to the WSJ titled "Our
  Ethical Erosion," former SEC chairman Arthur
  Levitt, Jr. and Richard C. Breeden criticized the
  mutual fund industry for
• high fees
• weak oversight
• hyping past performance
• extending preferential treatment to big investors
• They wrote that the time has come for a real
  clean-up

NEPC Agrees
3
The Mutual Fund Scandals the Beginning

• Day trading
• The failure to control and disclose short-term
  trading of mutual fund shares by employees and
  clients of investment firms
• Late trading
• The illegal purchase of mutual fund shares, or
  cancellation of an existing order to purchase
  shares, at the days closing price even though
  the investor placed the order after the funds
  closing time (400 p.m. E.T.)
• Market timing
• Frequent trading of mutual fund shares in
  anticipation of changes in market prices to make
  quick profits (like day trading)
• Sales abuses
• Directed-brokerage, shelf-space, brokers not
  paying investors the breakpoint discounts to
  front-end loads that they were entitled to, etc.

4
Recap How Late Trading Works
After Hours Good news breaks about Company X
whose stock is represented in Mutual Fund.
Company Xs stock expected to increase.
After Hours Late Trader reaps rewards of illegal
transaction.
Day One Market Closes at 4 p.m. ET Mutual Fund
share price struck at 10
Day Two Market Closes at 4 p.m. ET Mutual
Fund share price struck at 10.50
2
1
BUY Order
MutualFund 10 Share
MutualFund 10.50 Share

With new information, Late Trader puts in after
hours order to buy shares of Mutual Fund at
previous days close price.
.50 per share gain
Illustration compliments of CIGNA Retirement
Investment Services
5
Recap How Market Timing Works
FOREIGN MARKETS Overnight International Markets
trade and close higher
NEW YORK Market Day One Trading occurs during
day with US Market increasing in value
NEW YORK Market Day Two New price for Fund,
Investorsells shares at 4 p.m. ET
1
2
Intl Mutual Fund 10.00 Share
Intl Mutual Fund 10.50 Share
Investor was right, foreign markets rose with US
market.
BUY
SELL
International Mutual Fund holds stocks on
foreignmarkets.
Intl Mutual Fund price struck at 10.50
reflecting prior days gain in the foreign
markets.
Investor sees trend, with stocks rising in US
market, and purchases International Mutual Fund
shares, anticipating increase in the Funds share
price next day.
Investor sells shares after price increase, makes
profit from his 24 hour investment.
Illustration compliments of CIGNA Retirement
Investment Services
6
Recap What Were the Sales Abuses?

• Brokers selling the wrong share class to
  investors
• Selling B shares to investors who would be
  better off in the A shares
• Brokers not paying investors the breakpoint
  discounts to front-end loads that they were
  entitled to
• Brokerage organizations selling shelf space,
  i.e. spots on their favored mutual fund lists
• For cash or directed brokerage
• For revenue sharing
• Brokers steering investors into their own Fund
  families

7
The Mutual Fund Scandals - How Scandalous?

• 12 months of breaking headlines
• Early headlines with the Canary Compliant (Bank
  of America, Bank One, Janus, Strong, Security
  Trust)
• Big breaking headlines at Putnam (Top PMs trading
  funds, blowing the whistle on the Boilermakers)
• Tarnished reputations of well known industry
  figures
• Larry Lasser, Justin Scott and Omid Kamshad of
  Putnam
• Dick Strong of Strong Capital Management
• John Ballen and Kevin Parke of MFS
• Gary Pilgrim and Harold Baxter of PBHG
• Tarnished reputations of entire firms
• Putnam aum down 40 billion or 15 from end 2002
• Strong Capital Management sold
• Invesco US retail funds rebranded AIM funds

8
The Implicated Firms

• Late Trading
• Bank of America
• Bear Stearns
• Canary Capital Partners
• Charles Schwab
• Fred Alger Management
• Millennium Partners LP
• Security Trust Company
• Smith Barney

• Market Timing

• Sales Abuses
• American Express
• H.D. Vest
• Legg Mason Wood Walker, Inc.
• Linsco/Private Ledger Corp.
• MFS
• Morgan Stanley
• Raymond James
• UBS
• Wachovia Securities

• Alliance
• AMVESCAP
• Bank of America
• Charles Schwab
• Columbia
• Evergreen
• Franklin Templeton
• Fred Alger
• Janus Capital Group
• MFS
• Pilgrim Baxter
• PIMCO (PEA Capital)
• Principal
• Prudential
• Putnam Investments
• RS Investments
• Scudder Investments
• Seligman
• State Street Research

9
The Individual Settlements
10
The Settlements Overall

• Settlements to date are in the area of 2.5
  billion
• Settlement parlance
• Disgorgement (forfeiture of ill-gotten gains)
• Penalty
• Fee reduction (per NYAG)
• SEC has typically worked on a 11 ratio of
  disgorgement and penalty
• Fee reduction penalty gt disgorgement
• In Putnam case, penalty was 10 times disgorgement

Penalty
Fee Reduction 0.8 billion
Disgorgement 0.9 billion
Penalty 0.7 billion
11
Perspective 1 on the Magnitude of the Abuses

• Combined assets of the nation's mutual funds 8.0
  trillion

Mutual Fund Assets 8.0 Trillion
Disgorgement lt 1 billion Cumulative (about 1
basis point)
12
Perspective 1 (Contd)

• The cost to investors was not that significant in
  terms

Chasing returns 1 trillion over ten years
High fees 20 billion per year
Mutual fund abuses lt 1 billion cumulative
Altered from similar illustration by Forbes.
Sources AMG Data Services Lipper Forbes
estimates
13
Perspective 2 on the Magnitude of the Abuses

• Significant new regulation
• The SEC has mandated final rules on
• Investment Company governance
• Approvals of Investment Advisory Contracts by
  Directors of Investment Companies
• Prohibitions on the use of brokerage fees to
  finance distribution
• Portfolio manager compensation disclosures
• Shareholder reports and quarterly portfolio
  holdings disclosures
• Disclosure of breakpoint discounts
• Disclosure of market timing policies
• Technical amendment to mutual fund advertising
  rules

14
More Detail on the New Regulations

• Investment Company Governance
• Amendments to enhance the independence and
  effectiveness of fund boards to protect the
  interests of the shareholders they serve
• Funds have to be chaired by a Director without
  ties to management
• 75 of board members have to be independent
•  Independent Directors given resource to hire
  their own staff to carry out their duties

One of the most controversial rules. The US
Chamber of Commerce sued the SEC
(unsuccessfully), saying mutual fund investors
often select funds based on the reputation of the
Advisor who they expect will provide leadership
for the Fund. The rules change the balance of
power away from the Advisor.
SAI or Statement of Additional Information is
part of a funds registration statement and is
required to be delivered to investors upon request
15
More Detail on the New Regulations

• Approvals of Investment Advisory Contracts by
  Directors of Investment Companies
• Requires Funds to provide better disclosures on
  the BODs basis for the approval of advisory
  contracts
• The SAI has included similar info since 2001,
  but did not adequately address fees
• It is expected that this will put more pressure
  on BODs to justify the level of fees relative to
  those charged by the same advisors to pension
  plans

Early wins already? Just last week Capital
Research Management Co., which runs American
Funds, lowered the fees it charges investors for
managing each of its stock and bond mutual funds
by 10.
SAI or Statement of Additional Information is
part of a funds registration statement and is
required to be delivered to investors upon request
16
More on the New Regulations

• Prohibition on directed brokerage
• Prohibits funds from rewarding or incenting the
  distribution of their shares with brokerage
  commissions from December 13, 2004
• Better portfolio manager disclosures
• Extends the information required in a prospectus
  or SAI to include
• Members of management teams
• Other accounts they manage (SAI)
• Their compensation structure (SAI)
• Their ownership of securities in the Fund(s)
  (SAI)

SAI or Statement of Additional Information is
part of a funds registration statement and is
required to be delivered to investors upon request
17
Perspective 3 on the Magnitude of the Abuses

• Significant residual effects
• The scandals are still playing out with
• Hedge funds
• Insurance industry (annuity products)
• Brokerage operations
• Smaller settlements are still being announced
• Key Corps broker-dealer unit McDonald
  Investments Inc. - 275,000 to settle allegations
  it didnt have enough safeguards in place to
  prevent market timing and late trading in mutual
  funds
• Jefferson Pilot Variable Corporation - 325,000
  for failing to stop market-timers in sub-accounts
  of Ensemble series of variable universal life
  (VUL) insurance policies
• Alliance Capital - took a 5M charge against 2004
  earnings for a potential directed brokerage
  settlement

18
Perspective 3 (Contd)

• SEC is probing defined contribution plan revenue
  sharing
• SEC is probing pension consulting industry
• NEPC clean bill of health!
• SEC has informed us by letter, "no deficiencies
  or violations came to our attention during the
  course of our examination
• Public funds are stepping up their activism
• The Mutual Fund Protection Principles
• Investing in the retail world is transactionally
  more difficult
• Arbitrary 90 or 180 day holding periods

19
Conclusions

• The real magnitude of the scandals was
• Damaged investor confidence and trust first 6
  months?
• Marked increase in legislation and regulation
  next 2 years?
• Increased perception of fiduciary risk
  indefinite
• 90 of investment managers have no issues
• A fairly localized problem among mostly
  retail-oriented mutual funds and brokerage
  operations
• The 10 that do have issues, have issues

20
Conclusions andour Actions

• NEPC was one of the first firms to recommend
  client action
• NEPC placed the firms involved in the Canary
  Complaint on hold pending the outcome of the
  investigations
• NEPC sent its own questionnaire to more than 200
  investment managers to help formulate advice to
  our clients
• Has your firm been implicated?
• Have you reviewed employee trading activity?
• NEPCs Due Diligence Committee and Defined
  Contribution Team busy in 2004 and busy in 2005
• Manager issues within plans
• Redemption fee issues within plans
• Varied release dates on holdings data
• New focus on proxy voting