ARROYO GRANDE, Calif. – Get ready, folks. The great mutual-fund battle of 2006 is rapidly gaining momentum. Last year the fund industry dodged the bullet when its well-financed lobbyists killed the Senate's mutual-fund reform bill. Next year, however, things will be dramatically different.
That's why the title of John Bogle's (search) new book, "The Battle for the Soul of Capitalism" is a timely symbol of the coming confrontation, conjuring images of great battle scenes from "The Lord of The Rings," "Star Wars," "Saving Private Ryan," "A Bridge Too Far," "Sands of Iwo Jima" and Shakespeare's "Richard III."
Bogle's indictment is clear: "The business and ethical standards of corporate America, of investment America, and of mutual fund America have been gravely compromised."
And neither Congress, the SEC (search) nor the White House is interested in reform. So "divide and conquer" is the new battle cry: Over 25 cases in federal district courts across America. No more backroom deals. The battle of 2006 will be fought in courtrooms by aggressive plaintiffs' lawyers who won the tobacco cases. They smell fresh blood in the weakness of the fund industry's claims that it represents the best interests of shareholders.
Actually this is not a new battle for Bogle. He has been fighting for the little guy against all odds, battling the industry for more than 50 years. Late in his 70s, he presses on although he was tossed out of Vanguard, the company he built, and is no longer invited to industry events.
Bogle's on a mission. A couple years ago Bogle was asked if he was optimistic about industry reform: "No, I'm not optimistic. I'm certain. Why? Because investors may ignore their own economic interests for the rest of my lifetime ... but I guarantee you that investors will not ignore their own economic interests forever." Now, with the judiciary involved Bogle may not have to wait much longer.
The searchlight is focused on three specific concepts: Economies of scale, conflicts of interest and breach of fiduciary duties. Specifically, fund management companies are accused of cheating America's 95 million fund shareholders by making deals with pension funds that are far more favorable than the deals they make for their own shareholders, deals that put money in the manager's pockets at the expense of their own shareholders' returns.
Listen to the claims in the Strigliabotti vs. Franklin-Templeton Funds (search) case recently filed in San Francisco's U.S. District Court:
The shareholder, Strigliabotti, says that Franklin-Templeton provides "identical investment advisory services" to both its own shareholders and its institutional fund clients. However, the shareholders pay "dramatically higher fees" because Franklin-Templeton "repeatedly put their own financial interests ahead of [shareholders] interests by participating in arrangements and schemes that benefit [Franklin-Templeton] at the expense" of shareholders.
Worst yet, "the cost of this conflict of interest, which does not exist in the case of the arm's-length relationships with institutional clients, is manifest not only in higher fees, but in other losses and expenses borne" by their shareholders.
Of course all these claims must be proven in court. But for decades, these kind of cases never got to trial. Now judges are looking at new evidence focusing on economies of scale not passed on to shareholders. For example, in one Morningstar , the expense ratios of 13 of the 20 largest fund families actually increased between 1989 and 2004, even though assets grew tenfold. And Franklin-Templeton's expense ratio had the largest increase of all 20 fund companies during this period, nearly doubling from 0.56 to 1.02, while assets increased fourfold from $44 to $173 billion.
High cost of fund conflicts of interest
In the Strigliabotti case these out-of-whack "economies of scale" will be the fuel driving the trial. Strigliabotti cites a "landmark" study published in The Journal of Corporation Law titled "The Costs of Conflicts of Interest." This 2001 study by law Profs. John Freeman and Stewart Brown concluded that conflicts of interest "translate into fund shareholders being overcharged to the tune of nearly $9 billion plus annually — a staggering number." And by my count, folks, that's equivalent to a bonus in excess of $100,000 for each fund manager in America.
Bogle also did similar research in his book, comparing the operating expenses charged by three fund companies (Putnam, Capital Guardian and AllianceBernstein) for their advisory services to their own shareholders with what they charge the $166 billion California Public Employees Retirement System (Calpers).
There's a huge disparity exposing a breach of fiduciary duty: "How is it that those giant mutual funds managed by the same advisers — with assets averaging seventeen times as large as the pension accounts — are paying fees that average more than seven times the rate (0.61% vs. 0.08%), and nearly 100 times the dollars ($56 million vs. $600,000) paid by the relatively small Calpers?"
The obvious answer to his rhetorical question is that these fund companies, like 13 of the 20 fund companies in the Morningstar study, as more interested in "dis-economies" of scale because that way they can put more in their own pockets.
Witness stand tougher than congressional chambers
Today fund companies are protected by Congress and the SEC and keep secret huge amounts of relevant information about how much they are skimming from their own shareholders. But those protections will disappear under oath before a federal judge.
Can't you just see all those fund managers and directors squirming under cross-examination, trying to justify the huge disparities between expense ratios? And it'll be most interesting to hear how they defend their actions against challenges that they are in breach of their fiduciary duties to shareholders.
While they won't capture media buzz like the Michael Jackson and O.J. trials, these 25 cases in courts all over America promise to be great copy for financial journalists as "The Battle for the Soul of Capitalism" moves into high-gear in 2006. And I promise you, there will arise a grand drama rivaling the epic battles in The Lord of The Rings, Star Wars and the biblical battle between 95 million little Davids and the fund industry's Goliath.