COMMENTARY ON THE SCANDAL IN THE MUTUAL FUND INDUSTRY
by Preston Caves
Published  by Caves & Associates

November 14, 2003
Dear Clients and Friends,

I am writing because of the recent disturbing news which the media have named the mutual fund scandal.  Since Caves & Associates utilizes mutual funds as the predominant mode of investing, this scandal is particularly important to us.  To summarize, although I am disappointed by this latest scandal on Wall Street, I am pleased to report my assessment that "our" mutual funds and investment results are unimpacted by the bad news.
Background
The growing scandal involves improprieties and illegalities at both mutual fund companies and Wall Street brokerage firms.  To a considerable extent, the actions being reported are not technically illegal, but they involve failure to adhere to policies and procedures designed to protect the interests of long-term mutual fund shareholders and avoid unfair advantage to a select few.

At the core of the complaints is the issue of stale prices for fund shares, which can allow the offending parties to "game" the system by using market timing or late trading arrangements.  These arrangements have been directly with mutual funds as well as indirectly through broker/dealer intermediaries which handle mutual fund transactions.  Whatever the method, the offending parties take short-term positions in mutual funds and capture profits based on stale prices at the expense of long-term shareholders, thus diluting returns of the latter. 

Schwab
To the surprise of many, Charles Schwab has recently been drawn into the scandal.  The firm has admitted to a limited number of instances in which mutual fund orders may have been entered or processed in a manner contrary to Schwab’s order entry policies.  Two junior employees violated Schwab’s ethics policy by deleting related emails during Schwab’s internal investigation, and they have been terminated.  Schwab averages about 50,000 purchase and redemption transactions a day for over 4,000 mutual funds.

Actions Taken by Caves & Associates

We have monitored news reports, particularly watching for any negatives pertaining to funds owned by Caves & Associates' clients.  We have also reviewed the preventative policies and procedures in effect at the most susceptible mutual funds owned by our clients, namely, international stock funds.  Finally, we have communicated directly with current mutual fund managers to ascertain their level of enforcement of their own measures designed to protect long-term shareholders.

Analysis and Conclusions

Our clients have typically owned only one fund, Strong Government Securities, linked at all to the transgressions by fund management and/or brokerage firms.  We sold all positions in Strong about four months ago, considerably before this scandal erupted.  Even more important, a fund investing in government securities such as the Strong fund is not of the type that has been compromised by the practices summarized above. 

To review results of our questioning of the mutual fund managers we utilize, I am pleased to report all responses have been favorable as to our clients' interests.  The respondents are employing a number of appropriate practices to protect our interests.  These include: 1) short-term redemption fees to eliminate the profit of fund timers and discourage short-term trading, 2) daily monitoring of trading activity to identify and prohibit potential market timing activity and curtail excessive trading, and 3) fair value pricing, which causes stale prices to be superseded when necessary to avoid dilution of returns of long-term shareholders.
Finally, the investment results of the funds owned by Caves & Associates' clients speak for themselves.  All of our funds have outperformed appropriate comparative indexes.  This indicates to us that our returns have not been diluted by the improprieties and illegalities affecting the funds that have been the subject of the news coverage.  It also indicates that our fund managers have enforced their preventative measures and have not made the kind of discriminatory exceptions that have been uncovered relating to other funds.  Further, it is comforting to know that many of our managers are significant investors in their own funds.  As such, they have an added incentive to protect shareholders.
As for Schwab, they have reviewed millions of trades and to date there are 18 problematic trades that have been discovered.  The transgressions appear to be sporadic and not a systematic attempt to violate ethical standards or benefit a select group of Schwab customers.  I continue to believe that Schwab is a highly ethical company and a very good service provider for our clientele.

In Closing
I have purposely avoided going into detail about what are fairly complex and technical topics.  Please call me if you would like additional information, if you would like a more detailed explanation, or if you have any pertinent questions in this area.
It is unfortunate that the actions of a few continue to create an atmosphere of distrust in the investment industry.  We remain confident that the majority of participants are ethical.  Among mutual funds, we believe most operate in the best interests of shareholders. 
Thank you for your continued confidence in Caves & Associates.  We will strive to fulfill one of our most important company values, which is to diligently work in your best interest and to ensure that others are doing the same.

Very truly yours,


Preston S. Caves, CFP, MBA, CFA
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