Expanding probe may cut into fund firms' profits

NEW YORK -- Many mutual fund firms are enjoying strong quarterly earnings, thanks to growing investor optimism and a rebounding economy. But a widening regulators' probe into shady trading practices threatens to cut into fund firms' profits.

Massachusetts and federal regulators filed civil complaints last week against Putnam Investments for alleged improper activity. It was the first formal accusation of wrongdoing against a mutual fund company.

That comes after New York Attorney General Eliot Spitzer accused hedge fund Canary Capital Partners LLC in September of illegal trading involving Bank of America Corp., Janus Capital Group Inc., Bank One Corp. and Strong Financial Corp. funds.

And several other companies, including Merrill Lynch & Co., Alliance Capital Management Holding LP, Prudential Securities and Fred Alger Management, in recent weeks have suspended or fired employees believed to have engaged in illegal trading.

But while some fund shares have taken a hit on the news, the overall stock market recovery has driven up mutual fund assets, leading to higher revenue and profits. Analysts say the probe's findings so far might have come too late for third-quarter earnings and the impact could be felt later.

"The probe could affect every single company in the industry," said Rachel Barnard, a stock analyst at Morningstar Inc. who follows asset managers. "There certainly could be more revelations which have to make investors cautious."

Still, analysts believe the probe shouldn't dramatically hurt fund firms' earnings so long as the price tag of the scandal remains in the millions. That figure would be just a fraction of the $7 trillion total in industry assets.

Spitzer's complaint alleges illegal late trading, which Stanford University professor Eric Zitzewitz has estimated costs investors about $400 million a year. It also includes allegations of market timing, a practice that is illegal only to the extent fund prospectuses prohibit it; that activity is estimated to cost long-term investors billions of dollars.

So far, Bank of America and Bank One have pledged to pay restitution to harmed investors, but have not provided estimates on how much that will cost. Separately, Bank of America set aside $100 million to cover legal and consulting costs.

Meanwhile, the two banks reported better-than-expected profits, citing in part substantial stock market gains. Strong is a privately held company.

Janus said last week it swung to a third-quarter profit from a loss a year ago. However, it also posted a preliminary charge of $9 million for legal costs and refunds it planned relating to the mutual fund investigation.

But the average investor will likely get little compensation. Given that there are hundreds of fund firms and millions of investors, "anybody's restitution will be pretty small and overall company liability will be pretty small," Barnard said.

Mark Morgan, an equity analyst at Standard & Poor's Corp. who covers large banks, agreed. He doesn't expect Bank of America or Bank One to suffer greatly because their banking and other businesses can cushion losses from their mutual fund units.

In addition, the banks rely more on relationships between a broker and client to maintain its mutual fund business than a fund firm like Janus, which allows investors to trade directly online. Thus, Janus customers might be more prone to flee their accounts since they don't have brokers who could try to allay their concerns.

An issue of reputation

The probe "is not a deal breaker in terms of whether I buy or sell" bank stocks, Morgan said. "It's more of a reputational issue than a financial impact. ... Bank of America handled it well in terms of coming forward and making restitutions. It does take some money out of their pocket but it avoids a lot of problems in the future."

Indeed, the four fund firms named in the Spitzer complaint had investor outflows in September totaling $7.9 billion, or about 1.85 percent of their total assets, according to Lipper Inc. More than half of that amount, or $4.4 billion, came out of Janus funds.

That has led UBS Securities and other firms to lower Janus' earnings outlook for 2004, citing the increased risk of outflows in the near future.

Other fund firms, however, might represent good bargains, said Barnard, who likes the long-term outlook for companies such as Alliance Capital.

"It could be a good time to pick good companies on the cheap," she said. "The stock prices took a hit when revelations came out, but if you think long term over three to five years, this probably won't have a huge effect."