Mutual-Fund Industry’s Campaign Against Independent Analysts

by | Jan 2, 2004

Think the Mutual-Fund industry’s “late trading” and “market timing” abuses are scandalous? Well, I never quite saw what all the fuss was about. But now the mutual-fund industry is doing something that’s really scandalous. It’s engaged in a campaign to put America’s best securities analysts out of business. While I know it sounds incredible, I’ll […]

Think the Mutual-Fund industry’s “late trading” and “market timing” abuses are scandalous? Well, I never quite saw what all the fuss was about. But now the mutual-fund industry is doing something that’s really scandalous. It’s engaged in a campaign to put America’s best securities analysts out of business. While I know it sounds incredible, I’ll prove it.

But first, let’s talk about who these top securities analysts are. They’re not the lavishly compensated — and vastly overrated — superstars who work for the big Wall Street investment banks. No, the analysts I’m talking about are very different. Their firms don’t have any conflicted investment-banking relationships with the companies they cover. So these analysts don’t have permanent Buy ratings on every stock.

I’m talking about independent securities analysts; the ones who make a living not by being superstar salesmen for investment-banking services, but rather by making investors money by being right. And a lot of the time, that means making tough calls that are very different from the happy-talk that radiates endlessly from Wall Street.

For instance, there’s Mark Roberts, of Off Wall Street Consulting Group. Roberts has become famous for being just about the only analyst to have had a Sell rating on Enron as early as May 2001, well before the bottom fell out.

How about Howard Schilit of the Center for Financial Research and Analysis. Schilit warned about Microstrategy (MSTR) in October 1999, and the stock fell by 95% — the first of the major corporate scandals. He pointed to dubious accounting at Biovail (BVF) last July, and the stock fell nearly 50%.

Or David Tice of Behind the Numbers. Tice nailed Tyco International (TYC) in October 1999, Lucent Technologies (LU) in November 1999 and Providian Financial (PVN) in July 2001 — all major train wrecks that Wall Street blithely ignored until it was too late.

Scott Cleland of Precursor is an ace telecom analyst who called WorldCom’s business a “dead model walking” in January 2002, and predicted the company’s bankruptcy. And right at the top in 2000 he warned investors against Global Crossing, Qwest Communications (Q) and Level 3 Communications (LVLT), because his research exposed the myth of hyper-growth in Internet traffic, showing that actual growth was only about 1/15th as fast as these companies were claiming.

Independent analysts have positive opinions sometimes, too, of course. But over the last three years it’s been gutsy negative calls that have made investors the most money. And negative calls are calls that conflicted analysts at Wall Street investment banks just won’t make.

OK, now back to the mutual-fund industry’s campaign to put these courageous analysts out of business. To grasp how that campaign works, you have to understand how these independent analysts get paid.

Most independent analysts are paid with what’s referred to as “soft-dollar commissions.” With soft dollars, big institutional investors — including mutual-fund managers — don’t write checks to the independent analysts directly, but instead instruct their brokers to pay the analysts for the research. Why do the brokers agree to foot the bill? Because in exchange for brokers paying for the research, the big investors commit to sending the brokers enough trading commissions to make it worth their while. It’s a clean, explicit contractual arrangement. In effect, the cost of the independent research gets built into the commissions.

At first it may seem unfair that this business expense gets paid for with investors’ trading-commission dollars — dollars that in the case of mutual funds come from shareholders. But think again. Securities analysis and trade execution have been bundled in a single package for as long as there have been formal securities markets. For example, if you’re a big investor with Goldman Sachs (GS), you probably get reports from their famous software analyst Rick Sherlund. It may seem like the reports are free, but they’re really not. A chunk of your trading commissions goes toward paying for the research.

And it’s all perfectly legal. U.S. securities law gives explicit permission for this bundling of research and execution, in section 28(e) of the Securities Exchange Act of 1934.

Despite the legal and honorable status of soft-dollar commissions, now the mutual-fund industry’s Washington lobbying organization, the Investment Company Institute, has sent an open letter to the Securities and Exchange Commission urging the agency to ban the practice. It’s a way for a scandal-plagued industry to do something to look like it’s policing itself, by uncovering what can be made to seem like a tricky scheme in which mutual-fund shareholders’ money is employed to pay the research expenses.

But it’s not so tricky that any fund company will get in any real trouble over it. A 1998 SEC investigation of soft-dollar commissions established that there are virtually no abuses of it in the mutual-fund industry. Get real: If this were any kind of even vaguely real scandal, don’t you think Eliot Spitzer would’ve been all over it by now?

Scandal or not, it’s going to put independent analysts out of business. Why? Because the ICI is only asking the SEC to ban soft-dollar commission to pay for independent research like that of Roberts, Schilit, Tice, Cleland — and my own firm. The big Wall Street brokers will be allowed to go on just as before and pay for their own in-house research with soft dollars. So how are the independents going to compete when investors have to dig into their own pockets to pay them — but can still pay for Wall Street firms’ in-house research out of commission dollars that were going to get spent anyway?

Is it just a coincidence that the big Wall Street brokers come out on top, thanks to the mutual-fund industry’s attack on independents? Maybe not. The big Wall Street brokers are the ones whose sales forces are responsible for the majority of mutual-fund sales year in and year out.

The only good news is that what the fund industry is asking the SEC to do may, in fact, require an act of Congress to accomplish. At minimum, it will require a lengthy and very public review process at the SEC. So there will be plenty of opportunities for the truth to come out. And when it does, I hope that the mutual-fund industry emerges even more covered in shame than it is today.

But now, that’s not what the fund industry is thinking about. It’s barely thinking at all. It’s like a herd of zebras, under attack by a pack of hyenas — seized by fear, and doing anything it can think of to try to survive. I’m not exaggerating. When I talked to ICI spokesman John Collins for this story, he told me he has been praying lately.

“When they come,” he remarked, “I pray they take the young ones. They’re more tender.”

Precisely. Throw the independent analysts to the hyenas. Maybe some of the herd will survive.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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