Mutual Suspicion

by Aaron Pressman

Corporate scandals have turned America against Wall Street. Could Boston's all-important mutual fund industry be next?

Dan Geraci sits in his 18th-floor corner office in the heart of the Financial District, looking every bit the part of a successful CEO in his blue pinstriped suit, French-cuffed shirt with gold links, and suspenders festooned with images of overflowing money bags. His eyes dart frequently to a muted television set and the stream of stock prices running across the bottom of the screen. The head of Pioneer Investment Management USA, sixth biggest of Boston's prodigious mutual fund firms, Geraci looks like he just walked out of the movie Wall Street. But it's no longer the booming '80s, or the even more booming '90s, for Geraci and his friends around town in the mutual fund business.

With the stock market drifting and investors unwilling to throw good money after bad, mutual fund companies around town are being squeezed. Layoffs abound, with more expected. "It looks like every company around Boston is either going out of business or letting everybody go," Geraci gripes. That's somewhat of an exaggeration, but Geraci and others in his industry are certainly worried that further cutbacks are coming, that the city's financial talent base is eroding, and that real estate prices may take a dive as a result. "I don't want to be doom and gloom," he says. "I'm just trying to be realistic."

The fund community's troubles have not been of its own making — at least not so far. After all, few people predicted the stock market's rise would turn into a two-year rout. But now, with the pressure on, there is significant unease in the Financial District. Some in the mutual fund industry fear the impact of a potential scandal being unearthed, like those that have eviscerated public trust in corporate CEOs and their accountants — and which, after all, are keeping regulators busy elsewhere. And the mutual fund sector already has at least one little-noticed but potentially troubling accounting problem coming home to roost.

Barry Barbash, former head of the Securities and Exchange Commission's division of investment management, says the biggest risk to the industry's well-being isn't market turmoil but the possibility that lax enforcement and resulting bad behavior will torpedo its most important asset: investor trust. He fears the SEC may neglect the fund industry as it tries to grapple with the festering problems at Enron, WorldCom, and other corporations.

"The commission has to be a vigorous regulator, enforcer, and examiner," Barbash warns. "If it is not a rigorous enforcer, it will set the stage for a major problem in terms of companies not complying with the rules."

This is not an abstract threat. It's just what happened to some fund companies in the early 1990s when the SEC cut back on inspections, according to Barbash. "The result was you had a lack of regard for the regulatory scheme, and the result of that was you had a lot of problems," he says. "That's the biggest risk to the industry right now."

The corporate scandals have turned America against Wall Street. Could Boston's all-important mutual fund industry be next?

Downturn or not, this city remains at the center of the mutual fund universe. The very notion of a pool of money managed in trust for a group of investors began in 1924 with the Massachusetts Investment Trust, still in existence and run by MFS Investment Management (though crosstown rival Eaton Vance likes to crow that the brokers who crafted the original trust worked at one of its predecessor firms). Boston companies continue to hold the nation's greatest concentration of long-term mutual fund assets. Boston-based firms manage stock and bond mutual fund assets totaling $862 billion on behalf of investors, dwarfing second-place New York's $510 billion total, according to the Boston-based Financial Research Corporation. Of course, that's well below the figures chalked up just three years ago, when assets under management here peaked at $1.1 trillion. Since then, the drop has hit hard at Fidelity, Putnam, and John Hancock, each down more than 20 percent. Smaller firms, like Eaton Vance and State Street Research, have fared better. They're down less than 3 percent.

The fund business is all about asset size because fund companies earn most of their revenues — and profits — by charging a percentage-based fee on each fund. A huge fund like Fidelity's $60 billion Magellan generates more than $500 million in fees a year, on top of the 3 percent sales charge some investors pay to buy new fund shares. So when the market tanks, fund company revenues drop, too, and the city's economy suffers.

It's the mirror image of the mid 1990s, when the market went sky high and assets at funds citywide rose more than 20 percent a year for five straight years. Employment in financial services rose 25 percent, to 124,408. These were high-paying jobs with salaries exceeding, on average, $100,000 a year, giving the funds' employees a disproportionate impact on the city. "These folks are driving the local economy," says Mike Goodman, director of economic research at UMass's Donahue Institute. Now, with fund employees spending less, the fallout is already evident. At lunchtime these days, Financial District restaurants sit empty while office workers in business suits line up at sandwich stands. Over the last 12 months, the industry has posted its first net job loss in at least 15 years.

Up or down, the mutual fund business remains central to the city's growth. More than one in five new jobs expected to be created in Boston by 2008 will be at mutual fund companies, according to projections. The industry is also a major contributor to the state treasury. When year-end bonuses declined by more than 50 percent from 2000 to 2001 — a staggering drop of more than $5 billion — the state lost $300 million in income taxes. That was a good chunk of the revenue shortfall the governor and legislator spent the summer arguing about. "The drop-off of these bonuses in the financial industries," says Goodman, "was a major factor in the decline in revenues and the resulting financial crisis."

How much future job growth actually materializes also will determine which way the city's real estate market goes. Fund companies are critical office tenants, says Susan Hudson-Wilson, CEO of Property & Portfolio Research. "It's the most important business in the metro area," she says. "As employment in the mutual fund sector ebbs and flows, that is going to make a big difference in the commercial real estate sector."

Even if the stock market does come around, the fund industry can't regain its former glory unless investors feel they can trust it. Minor past scandals haven't seemed to hurt investor confidence, but some insiders worry that their luck won't last.

The funds operate under the supervision of the Securities and Exchange Commission. There are so many funds in Boston, the agency has an office here.

Last year, the SEC investigated 228 fund families nationwide, or about one-third of the industry total. More than 90 percent of these inspections turned up minor problems, such as omissions from regulatory filings, though only eight cases were referred to the commission's enforcement division for more serious problems like possible fraud or prohibited conflicts of interest.

"No industry is without problems," says Arthur Levitt, who headed the SEC from 1993 until last year. Still, he says, "the mutual fund industry understands that the future is no better than its weakest link. The best companies are mindful of their public responsibilities. There are outliers who lie and cheat and steal." That's the greatest threat, says Barbash, who headed the SEC's mutual fund division from 1993 to 1998.

The industry itself disputes such dark predictions. "The industry has always been dedicated to compliance beyond the law," says Matthew Fink, president of the mutual fund trade association, the Investment Company Institute. Fund firms have rules prohibiting the sort of conduct that led to many of this year's corporate scandals, Fink points out. It's industry practice that fund managers can't personally buy into initial public offerings or profit from short-term trades, for example. Fund company dealings with affiliated companies are also limited.

The companies, Fink says, have elaborate controls to prevent mischief, beginning with their very structure. All assets are held by a custodian — usually a big bank like State Street — not at the fund company. Fund managers direct trades but don't have access to the money.

"The money is not sitting at the mutual fund companies. It's actually at a bank," says Scott Stewart, a former Fidelity fund manager who now teaches at Boston University. "I can't call up and say, 'Wire $50,000 to my account in Rio.'"

If there are clouds on the fund industry's horizon, the darkest may be forming around the millions of so-called B shares that fund companies sold during the height of the bull market. After helping juice revenues at the firms when the stock market was rising, the B-share phenomenon is now sucking away profits.

Instead of charging investors a one-time fee of 4 or 5 percent, B shares typically carry a lower 0.75 percent fee that's charged once a year for six years. But the brokers hawking the funds don't want to wait around for six years to get their cut. So when B shares are sold, the fund companies pay brokers the full up-front fee, just as if the customer had bought a fund with a front-end load.

The strategy boosted income at the fund companies when the stock market was rising because as the value of a customer's funds rose, so did the fees collected by the fund company. Say a customer bought $1,000 worth of B shares in a stock fund. The fund company immediately paid the customer's broker $40, but if the value of the customer's fund shares rose 10 percent a year over the following five years, the fund company collected more than $50. The same magnifying effect works in reverse when the stock market declines. A fund company that paid the broker $40 at the outset would collect less than $28 over five years if the market fell 10 percent a year.

In some cases, fund companies will get back only about half the money they paid to brokers, according to Russ Kinnel, director of fund analysis at Chicago-based Morningstar. "The bear market alone hurts profitability, but making it even worse are the fund companies that sold a lot of B shares in 1999 or 2000," he says. "It's a real pressure point."

Within each fund company, the up-front fees paid to brokers on B shares are totaled, and a portion is counted as an expense spread over several years, a process known as amortization. The companies must track whether current fee collections on B shares are sufficient to cover the amount being amortized.

Jim Hawkes, a gray-haired industry veteran who runs Eaton Vance, says his management committee and board of directors regularly want information about the status of amortized fees. Hawkes can at least deliver a reassuring message, thanks to increasing fee income from bond funds, which have performed well as the stock market has slid. "We're not even close to the point where we'd have an impaired asset," he says.

But Kinnel and others say Putnam, which has seen big declines at its largest equity funds, could be suffering from a B-share squeeze. Putnam itself would say only that it was "committed to offering investors a range of choices in the way that they can invest in Putnam funds." MFS, another fund merchant tabbed by Kinnel as facing a potential amortization problem, says it's in a "positive position" with regard to B shares.

If the stock market doesn't turn around soon, it's a squeeze that will only get tighter — for fund companies and this city's economy alike.

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