Mutual Fund Scandal To Get Worse, Much Worse!

INVESTING
Mutual Funds: The Scandal May Get Much Worse

Illegal behavior at funds is so longstanding and pervasive, rising to the highest levels in many cases, that some fund firms could very well ‘crumble’ as investigations proceed, says one plugged-in independent investigator.
By Geoffrey Colvin

The hot-button issue of the moment is the developing mutual fund scandals. And the man who may be the most plugged-in independent investigator of mutual funds, Edward Siedle, said in an interview on "Wall Street Week with FORTUNE" Friday, that illegal behavior at mutual funds is so longstanding and pervasive, rising to the highest levels in many cases, that some fund firms could very well "crumble" as investigations proceed. That's a much more disturbing scenario than anyone has yet predicted, but Siedle's credentials make it impossible to dismiss. .

Meanwhile, First Pacific Advisors CEO Robert Rodriguez, a highly successful fund chief whose firm has been cited by FORTUNE and others as among the few you can still trust, revealed on the same program that he has turned bearish on stocks after being a notably ebullient bull since early this year—a significant change in stance he had planned to announce to his investors in a couple of weeks. .

First let's talk about the fund scandal. Siedle is not well-known to the general public, but soon may be. He's an attorney who once worked in the SEC's Division of Investment Management, which oversees the mutual fund industry. He has also worked on the other side of the table: Back in the '80s he was Putnam's director of compliance. Now he runs his own firm investigating mutual funds on behalf of giant institutional investors. So he knows where to look, and he's seen it all. .

His conclusion: "Illegal trading is pervasive, and it's longstanding. It's been going on for the last 20 years, and it costs investors billions." Note the language: Not "trading abuses" or "questionable practices," but "illegal trading"—flat violations of law. He's talking mostly about behavior that hasn't been in the news much so far, personal trading by top fund executives, things like front-running, which is putting in a personal buy or sell order just before placing a mammoth order on behalf of the fund, which is sure to move the price up or down. .

No one would be shocked to discover such behavior at a few of the hundreds of fund firms. But Siedle says that far from being rare and scattered, such behavior is endemic—a fact of life at "most firms." .

This is serious, and it gets worse. Siedle told me, "There's no question in my mind that the senior management of many of the leading fund companies have participated in wrongdoing, have been involved in criminal activity amounting to obstruction of justice." Again, note the language: "senior management," not middle managers, at "leading firms," not the two-bit operations that so often break the rules on Wall Street. And then the sledgehammer charge: "criminal activity," not just unethical behavior or violating internal codes of conduct, but real go-to-jail stuff. .

Siedle speaks in quiet, matter-of-fact tones, so the full implications of his words take a few moments to sink in. When he said the above, I paused, then replied, "What you're saying suggests that the survival of some of these funds could be in jeopardy." His response: "We strongly believe that. We believe that the wrongdoing is so longstanding, involving such significant amounts of money, that it could very well cause some of these firms to crumble, or survive in much reduced fashion." .

Of course the main financial industry enforcers, SEC chairman William H. Donaldson and New York attorney general Eliot Spitzer, are making no such expansive statements, refusing even to discuss current investigations. But Edward Siedle has an emphatic view of what those investigations will uncover if they're taken far enough, and his view must be taken seriously. The fund industry's travails, bad as they seem today, may have scarcely begun. .

As for Robert Rodriguez, his First Pacific Advisors is a widely admired shop that has dared to go public with declarations that it's clean. Let's hope he's right. He's also a market observer with an excellent record, having warned that stocks were overpriced in 2000, then going bullish last spring—two bang-on calls. So it's newsworthy that now, with stocks up more than 35% in 13 months, he believes they're too high. .

Specifically, he told "Wall Street Week with Fortune" viewers, "We are going to be a net seller of stocks over the course of the next six to nine months (because) optimism and speculation have risen to elevated levels, in contrast to what we had written on our website and in our shareholder letters earlier this year." .

Rodriguez also offered mutual fund investors a warning: Many funds will soon be touting their performance over the past year, when the whole market has been up strongly, and won't mention their performance over the past three years, which is likely to look much worse. So, buyer beware.

In the fund industry, it's more timely advice than ever.