November 2003
Act with integrity, dignity, and in an ethical manner when dealing with...clients.
Association for Investment Management and Research - "Code of Ethics"
The honesty and integrity of the financial services industry has once again been called into question but this time from a more unlikely source, the mutual fund industry. It seems that the corruptive force of greed may have infiltrated many of the larger and well-known mutual fund companies and made some good people do some bad things. It is alleged that these self-proclaimed "champions of the small investors" provided some of their larger customers and own employees opportunities for illegal trading profits at the expense of ordinary investors. Although disappointed by the news, we are not surprised. We have all seen it happen before in environments where sales and profits are the driving concerns, rather than simply doing what is best for the client. This questionable behavior also seems to flourish in organizations where there is no direct, eye-to-eye contact and accountability with the investors or clients. We think managing money and investments for people is a very personal business built on trust. We value that trust and protect it by conducting our professional lives by a Code of Ethics that, when combined with the character instilled in us by our parents, ensures that we do the right thing for our clients and community.
We founded this firm based on the principle that it is an honor and a privilege to be entrusted with the fiduciary care of our clients' investment portfolios. We take this responsibility very seriously as witnessed by the large bottle of Mylanta that I keep readily available. We also believe that each of our clients deserves to be treated with the same professional attention and care because every investment portfolio, no matter how small, has hopes and dreams and even a security blanket attached to it. Okay, enough preaching. Moving on to the scandals.
Good Mutual Funds Gone Bad
Mutual fund companies like Janus, Strong, Putnam, and Alliance along with hundreds more of their brethren have been accused of letting a number of their larger shareholders skim some of the fund's profits off the top, a little bit at a time. They supposedly allowed a select few to break trading rules and regulations with "market timing" and "late trading" arrangements to achieve quick profits at the expense of the other fund shareholders. Market timing allows knowledgeable traders to profit from time differences between the various closings of the international markets and that of the U.S. markets. Late trading refers to purchasing or selling mutual fund shares at the 4 p.m. closing price many hours later after new information is learned. Not only did the ordinary shareholders not get the chance to earn these ill-gotten gains but their returns from these funds were reduced because of this activity. In some cases the perpetrators of these trading abuses involved a fund's own portfolio managers (Putnam) and even a fund's founder and his family (Strong). Not to be left out, both Merrill Lynch and Prudential Securities recently fired some brokers who were participating and facilitating some of these trading schemes.
These trading abuses are the primary focus of current investigations by the New York Attorney General, Eliot Spitzer, and the SEC but, unfortunately, there are other issues within the mutual fund industry that are also being addressed. For example, the brokerage firm, Morgan Stanley, recently had to pay a $2 million fine for allegedly using prohibited incentives like tickets to the NBA finals and to Britney Spears concerts to prod their own brokers to sell the company's own mutual funds regardless of performance records or account suitability. (Personally, I wouldn't hire a broker who is young enough to want to go to a Britney Spears concert.) The SEC has also been looking into mutual fund prospectuses to see if they adequately describe the types of securities in which the investment managers of the funds are allowed to invest. Some income funds have been found to be stretching the definition of U.S. Government securities to include U.S. Agency securities, which are not backed by the full faith and credit of the U.S. government as U.S. Treasury securities are. Warning! We are going to start preaching about ethics again.
Profits Over Clients' Needs
In our opinion, questionable business practices like these are the direct result of placing what is good for the business and the financial advisor (i.e. brokers, planners, consultants, or whatever they call themselves today) ahead of what is best for the client or investor. It is true that sales incentives and commission-based compensation within the financial services industry are declining. Most brokerage firms are in the process of transitioning commission-based business to fee-based which does better align the broker's compensation with the client's investment goals. However, we think these large financial institutions, including the bank trust departments, are still guilty of promoting investment services and products that, while technically appropriate, are primarily designed to improve their own profitability rather than to achieve a particular client's investment objective. To handle the large number of clients, practices such as categorizing their clients with labels and then mechanically putting them into a predetermined allocation of mutual funds leaves no room for customized investment solutions. True customization tends to be left only for the largest clients.
In addition to the lack of customization, the investment management responsibility for most accounts is often handed off to a person or group of people with whom the clients have little or no interaction. In many cases, there is no direct accountability between the actual portfolio managers and the client. Real accountability to clients is vital to a successful long-term relationship and we believe these kinds of impersonal cultures are prime breeding grounds for the types of abuses that are now being exposed in the mutual fund industry.
Our Code of Ethics and Standards of Professional Conduct
Both Jason and I are Chartered Financial Analysts (CFA's), which is a globally recognized standard for measuring the competence and integrity of investment managers. We are also members of the Association for Investment Management and Research (AIMR) whose mission is "to serve its members and, through them, to serve investors as a global leader in educating and examining investment managers and analysts and in sustaining high standards of professional conduct". We know that a lot of people have letters after their name and highlighting it is somewhat self-serving, but we want you to understand how our designations relate to our commitment to ethical behavior as professionals.
As CFA's and members of AIMR we are bound to apply the Code of Ethics and Standards of Professional Conduct in our daily investment practice. The Code affirms a set of principles that govern appropriate behavior and the Standards provide the minimum rules of conduct to which we must adhere. We must submit an annual Professional Conduct Statement that inquires as to whether our professional conduct has been challenged by anyone in the past year. Any serious infraction will be investigated and disciplinary action will be taken when appropriate. We both worked hard to achieve the CFA designation and would never do anything to jeopardize it. Although there are too many Standards to discuss in this newsletter, suffice it to say that the primary focus is on doing what is right for the client with no regard for personal gain. In fact, it is our duty to clearly disclose to our clients any conflict of interest where we might personally benefit from an action we might take on behalf of a client.
Although there have been some exciting returns earned so far this year in the stock market, we believe that the financial markets will be very challenging for investors and portfolio managers in the years ahead. The best business strategy for a firm like Front Street is to build and maintain our clients' trust by ensuring that everything we do is in each client's best interest and by clearly communicating our strategies and results to them as often as they need to hear it. Scandals on Wall Street hurt all of us who provide investment services but we know we can overcome them by doing the right thing for our clients.
John W. Gudritz, CFA
john@frontstreet.com