Dear friends,

Welcome to the start of summer. A season of quieter days, warmer weather and, apparently, heightened silliness on the part of folks who want your money. While the number of new fund filings with the SEC dropped to surprisingly low levels, the amount of foolishness of the part of the folks already in operation remained reassuringly high.

The federal courts handed down two major victories for the mutual fund industry on consecutive days in May. I was struck by the fact that the industry’s mouthpiece, the Investment Company Institute, had comments on only one of the two, so I went looking to see why.

In the first case, Department of Revenue of Kentucky v. Davis, the U.S. Supreme Court upheld Kentucky’s decision to make interest paid to Kentuckians on Kentucky muni bonds tax-free while taxing them for interest paid by out-of-state munis. ICI promptly commented:

The second case, Jerry N. Jones v. Harris Associates, was potentially a far bigger deal, and represents a far larger economic stake. The Jones plaintiffs argued that Harris Associates, the sponsor of the Oakmark funds, charged unreasonably high fees, and that the "incestuous" relationship between fund boards and fund advisors made it impossible for retail investors to receive fair treatment.

The good news for the plaintiffs is that the court avoided spitting on them, though just barely. You can see the impulse to spit when Judge Easterbrook, writing for the 7th Circuit Court of Appeals (that’s one step below the Supreme Court), opens his decision with the line "Plaintiffs rely on several sections of the Act . . . and we can make short work of these." But at least the judge didn’t call Jones’ argument "nutty" or "goofy" (words used to describe another plaintiff’s argument), and the judge managed, barely, to avoid characterizing the Jones case as "frivolous" and "doomed" (as in Kale v. Obuchowsk (1993)), so perhaps Jones won a sort of moral victory. In the end, though, the Court essentially held that if Jones wanted a low-cost mutual fund, he should have bloody well shopped around the bought one in the first place. Case dismissed.

That’s a pretty clear win for the industry, so why is it that the ICI "declined to comment on the ruling" for The Wall Street Journal ("Court Backs Oakmark Funds in Fee Case," 28 May 2008)?

There are two elements of the decision that the ICI likely wishes weren’t there. First, the Court notes – and doesn’t refute -- the "incestuous" relationship between fund boards and fund advisors. Second, based on federal law, the Court concludes that fund boards of directors don’t need to negotiate "reasonable" fees on behalf of shareholders. Boards merely have a fiduciary responsibility to negotiate fees which are "ordinary" for the industry. Do fund fees seem high to you? Tough nuts, says the court, but so do some CEO compensation packages, $500 an hour attorney fees, and 33% attorney contingency awards. What all of these payments have in common is that they are (at least theoretically) set by competitive market forces. In a competitive marketplace, courts shouldn’t act as "rate regulators" or setters of a "just price." (The plaintiffs in Jones weren’t necessarily asking the court to assume these roles, but who doesn’t like a little straw man once in a while?)

Ultimately, Judge Easterbrook’s findings raise two important questions: (1) why do we even have boards of directors if their only task is to ratify whatever request the advisor makes? And (2) doesn’t this mean that fund investors are screwed?

Okay, I’ll withdraw the first question since we already know the answer.

Good news on the second question! Judge Easterbrook says you’re not screwed. The rich people will protect you: "The sophisticated investors who do shop create a competitive pressure that protects the rest." By "sophisticated investors," Judge Easterbrook means people rich enough to buy into hedge funds, which have really high expenses but aren’t available to average folks. And since rich folk are willing to pay the high costs associated with hedge funds, "it is hard to conclude that Harris's [lower] fees must be excessive." Oh, now I get it, it’s the famous Trickle-Down Theory of Investor Ignorance: Rich people make dumb investment decisions, which ensures that the rest of us will have the same opportunity.

Next time, maybe we’ll get a judge who actually has a clue how the money management business works.

The Wall Street Journal may inadvertently have revealed one of the fund industry’s best, and most dangerous, ideas: the Mutual Fund Self-Destruct Sequence. The device’s existence was revealed in an article about a pair of too-clever-by-half ETFs invented by Robert Shiller. One ETF was Macroshares Oil Up and the other was Macroshares Oil Down. Since actually owning oil was a headache and most of its competitors already owned oil futures, Oil Up and Oil Down simply bought and exchanged Treasury bills. If oil went up 1%, the managers shifted 1% of Oil Down’s assets to Oil Up, to the profit of Oil Up shareholders. The reverse would be true when oil went down and the two funds would ride a sort of teeter-totter as oil bounced higher and lower.

" Holy cannoli, Batman! The diabolical fiends!"

Except the market didn’t cooperate. Oil went higher but didn’t go lower, so money was steadily drawn from Oil Down. Since the ETFs were equally capitalized at launch and oil cost $60/bbl back then, the system would work perfectly except in the extremely unlikely case that oil topped $120/bbl. The funds’ creators thought that extremely unlikely but not impossible, so they had a contingency plan. Diya Gullapalli described it this way: "When oil approached $120, the Oil Down ETF was almost out of money, and the fund’s automatic self-destruct mechanism kicked in" ("Falling Off an ETF Seesaw, WSJ, May 10-11 2008, B1).

This strikes me as a potentially-brilliant marketing idea. A few funds have made a commitment to close right in their prospectuses. That sort of commitment strikes me as good for the shareholders and good marketing. It lets potential shareholders know that the managers are thinking ahead and that they’re willing to sacrifice some of their own profit (from larger asset pools) for the sake of protecting their shareholders’ interests. A few more funds have performance-based fee structures, where the managers tie their own compensation directly to performance: sustained underperformance leads to a sustained reduction in fees.

But no other fund has taken the radical step of promising that they’ll simply shut the fund down if they’re incapable of serving their investors better than a simple, low-cost index fund would. That would be bold. Forward-thinking. Striking. Highly principled. And . . . oh well, it was worth mentioning.

Winston Smith was the protagonist of Orwell’s 1984. His job at the Minitru was continually rewriting old newspaper articles so that the past could be kept up to date with the present. For example, if an old New York Times article said something that could no longer be true ("Minister X worked with Colleague Y in 1980" couldn’t be true if Colleague Y had become an "unperson"), Smith would go back to correct history.

Against all expectations, Wasatch Microcap Value (WAMVX) has remained open for an entire month. WAMVX, you may recall, closed to all investors on the same day it opened in July 2003. After four very solid years, it lost 14% in the first quarter of 2008 and reopened to all investors on May 1^st. My guess was that it might be closed by . . . oh, May 2^nd. Wrong again, chubby cheeks!

Good news for Janus Capital: For the second month in a row, none of its managers have resigned! And good news for Janus CEO Gary Black: Janus shareholders paid him $9.2 million for his efforts in 2007. That’s dimmed only slightly by the fact that they paid him $15 million the year before. Black’s compensation figures were among those collected from SEC filings by the Fund Action news service. The same story notes that the lovely Mario Gabelli topped the compensation list (again) by paying himself $71 million, a 25% raise from the year before. ("Incentives Boost CEO pay," 5/28/2008).

A motto for Morningstar’s mugs: "Monopoly...is a great enemy to good management." Adam Smith, The Wealth of Nations, 1776. Morningstar has a virtual monopoly in the fund rating business. Eventually even they might come to regret the lack of competition which would keep them on their toes. That possibility came to mind the morning that I tried to answer a query on FundAlarm’s outstanding discussion board. "Bruce" asked, as many have before him, for a recommendation for a fund with a low investment minimum. Trying to be helpful I ran a quick screen at Morningstar for funds with automatic investment plan minimums of $100 or less. At which point the software blithely kicked out more than a hundred erroneous results: they reported a $100 minimum for Aegis Value (it’s $10,000), a $2500 minimum for all of the T. Rowe Price funds (it’s $50), the absence of automatic investment plans for any Fidelity or Schwab funds (they all have such plans, most with a $100 minimum), misreported Wasatch Microcap Value as closed, and on and on. All of which might be less likely if there was the imminent threat of someone taking business from them when they got sloppy.

May was a month of passages at Augustana. Some of the passages were part of the rhythm of academic life as 500 seniors receive their degrees and a handful of teachers bid farewell. Their departure is always bittersweet. The most poignant of the departures came with the sudden death of Glenn Robinson, a long-time professor of Political Science. Glenn was dying of cancer and knew it. Friends urged him to let someone else finish teaching this term for him. They wanted him to admit defeat and seek the solace and support of a hospice. He refused. In a cancer-dimmed voice he declared, "I am going to finish this term." And so he did. Glenn died in his home office on May 23^rd, precisely one day after administering his last final exam. He died as he lived, alone except for the company of books and the memories of students.

Old Main through the flowering almond.
My office is in the far left corner of the picture.
Photo courtesy of Daniel Hadley ’08, Augustana Photo Bureau.

I’m always a little stunned by evidence of the ability of the human spirit to deflect death until the moment of passing is right. He was a good man and cared rather more than he’d ever admit. He had an elite intellect but consciously chose to deploy it in the service of distinctly less-than-elite students. He argued that some students would find their way quite well without guidance but that others would stumble and get lost without it. So rather than devote himself to the Phi Beta Kappa kids, he devoted enormous energy to helping the others figure it out and find their way through. And in that humble task he may have made a greater difference in more lives than a dozen of his old Harvard chums would.

If you’re at the stage of life where college looms, buy a bigger mailbox because there’s an avalanche on its way. If you’re at that stage and want to help both FundAlarm and yourself, consider using FundAlarm’s link to Amazon.com to buy a copy of Loren Pope’s, Colleges That Change Lives (2006 edition). Regardless of what you think of Pope’s individual college profiles, he’s got several introductory chapters that are clearer and better argued that anything else you’ll find.

On the financial front, I recently discovered that Bill Bernstein (he of the Efficient Frontier Advisers and The Four Pillars of Investing) just wrote a book on the effects of world trade. It’s entitled A Splendid Exchange: How Trade Shaped the World (2008). One reader compared it to a great adventure novel and Jack Bogle got giddy enough to conclude it’s "a book as good as--if not better than--any other book you'll read in 2008." George Soros (billionaire investor, philanthropist and philosopher) just released The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means (2008), wherein the great man tries to dissect "the worst financial crisis since the 1930s." Both are available through, well, you know: FundAlarm’s link to Amazon.com.

And if you’d like to do something with your Economic Stimulus Payment, other than fritter it away on a tank of gas, you might consider a simple and easy contribution to help keep FundAlarm running through Amazon’s Honor System or PayPal. Details are here.