Competing for headlines

Alan Reynolds
Posted: Nov 20, 2003 12:00 AM

It was unseemly enough when the chairman of the Securities and Exchange Commission, William Donaldson, was obviously competing for the headlines with Elliot Spitzer, attorney general of New York. Now they have resorted to dueling rhetorically in the op-ed pages of The Wall Street Journal and The New York Times, respectively. As one headline put it, "Spitzer and SEC Fight for Turf." Turf involves dirt, if not mud.

Spitzer landed the first punch, criticizing an SEC settlement with Putnam and announcing that "the public will have to rely on state regulators." For one thing, wrote Spitzer, "the agreement does not address the manner in which the fees charged to investors are calculated." It also does not address the price of tea in China. As Donaldson explained, "We should not use the threat of civil or criminal prosecution to extract concessions that have nothing to do with the alleged violations of the law." Spitzer nonetheless threatens hugely expensive "concessions from the industry" even though the Putnam case is unique to that firm and unrelated to those concessions.

Spitzer has made unproven accusations of unknown significance against only a few other firms in the industry, yet journalists nonetheless keep alluding to an industry-wide "scandal." Donaldson opined that "the industry lost sight of ... its responsibility." That was unfair and untrue. The mutual fund industry consists of many firms, the largest of which have not even been accused of doing anything wrong.

Cartoonist Peter Steiner draws two fellows in a prison cell. One says, "If only it had been the SEC after us instead of the cops." Funny, but wrong. The SEC has no authority to put anyone in jail. Elliot Spitzer does have authority to prosecute actual fraud, but accusations of fraud are easier made in the press than in court.

Trying cases in the press is a cheap way to finance a political campaign and a lucrative way to finance the state government, and it avoids all those annoying legal protections accorded to defendants in a courtroom. "Industry-wide concessions" may also be extracted, which amounts to state prosecutors writing law without asking any elected legislators.

Many of those proposing solutions to the "mutual fund scandal" also happen to be selling something. One proposed solution involves requiring funds to constantly estimate fair value of their shares throughout the day, rather than once at 4 p.m. There is no sure way of doing this, and any method would be an open invitation to lawsuits by investors claiming they were overcharged at the moment they bought and underpaid at the moment they sold. But The Financial Times markets a Fair Value Information Service to mutual funds, as do several others.

The New York Times notes that Eric Zitzewitz, the young economist with by far the largest estimate of the benefit and cost of market timing, "is helping to develop software that would allow funds to keep their prices fresher." We will know if such methods are really superior only if investors are free to choose them or to stick with funds that use today's simpler solution. Meanwhile, Zitzewitz collects favorable media references on his webpage like trophies.

John Bogle, the admirable founder of Vanguard funds, has lately been featured in op-ed pages and interviews engaging in what might otherwise be disregarded as knocking competing firms and touting his own. His remedies naturally tend to involve compelling other fund companies to do what Vanguard does. Bogle has long been an enthusiastic salesman for funds that copy a stock index -- for example, which requires no research and therefore modest fees. The standard sales pitch has been that most mutual funds failed to beat the S&P 500 index. But "most mutual funds" does not mean "most money invested in mutual funds." Most money is in 10 dozen giant funds, 85 percent of which have beaten the S&P 500 handily over the past five years. A Vanguard study shows the average 401K also greatly outperformed the S&P 500.

Bogle boasts that Vanguard's index funds prohibit redemptions after 2:30 p.m., suggesting competing funds should be required to impose the same inconvenience on customers. He also suggests imposing his index funds' steep redemption fee on investors who want to sell shares in any competing fund until a few months have passed. If investors admire redemption fees, they can easily find funds willing to collect them. Many international funds -- including Putnam's -- already impose a fee on early redemptions. Industry lobbies admire any proposal to require all funds to charge any fee, because collecting fees is profitable but may lose customers if other funds don't do it.

The trouble is that any penalty fee on selling reduces a fund's liquidity -- its ability to be cashed-in whenever need arises. Spitzer and company evade the liquidity issue by separating virtuous "buy and hold" investors from demonic traders. If you buy and hold a sinking mutual fund, however, then you made two mistakes -- first buying and then holding. What if you found out a while back that your new fund had big holdings of Enron and WorldCom?

Reducing liquidity would make mutual funds less desirable to many investors, which is why banks have to offer a higher interest rate on 2-year CDs than on 3-month CDs. Any proposal to require fees, like any proposal to require taxes, should be decided by elected legislators rather than publicity-hungry bureaucrats or prosecutors.

We are suddenly awash with media advice on how to pick a good mutual fund, and gaining wealth appears to have nothing to do with it. A good fund, we're told, charges a fee if you sell too quickly. If you prefer to invest in such a fund, you are free to do so. A good fund, we are also told, is one that closes itself to new investors if it gets too large. What sort of hot tip is that? If you want to invest in a fund that is closed, you are out of luck. Companies that close a popular fund often offer a new fund with a similar name, yet such bait and switch tactics have suddenly become another media-defined virtue.

Investors want good information, not regulatory marching orders. The SEC supplies the sort of information we have come to expect from bureaucrats and lawyers -- endless pages of stale and indecipherable gobbledygook. Useful and cheap information about mutual funds comes from the surveys and ratings regularly reported in many newspapers and magazines. Useless and costly information comes from federal and state regulators fighting over turf.

Mutual fund investors urgently need protection from turf warriors who claim to be so eager to protect them.