A Mutual Problem for Investors

As the wildfire of corporate scandals rages around us, it’s clear it’s being fueled by the dry rot of conflicts of interest: accountants double-dipping as consultants, Wall Street analysts acting as investment bankers, politicians turning a blind eye to the dirty deeds of their campaign donors.

Yet there is another, even more combustible conflict of interest that has yet to hit the headlines. The two-faced status of mutual funds managers.

Mutual funds are now among the largest owners of American corporations--controlling close to $3 trillion in stock. The 75 largest mutual fund companies control 44% of the voting power at U.S. companies. So there are enormous consequences for all of us when the owners elect not to act like owners but like timorous lackeys desperate to please management.

But that’s exactly what’s happening because of a gargantuan conflict of interest: The giant mutual funds are serving two masters. As owners of huge amounts of stock, it is their job to hold management accountable. But there are massive fees coming their way when corporate executives award them 401(k) and pension fund assets to invest.

For instance, the nation’s largest mutual fund, Fidelity, which owns 5.3% of Tyco’s stock, also earned $2 million in 1999 for its part in running Tyco’s 401(k) plans. Last year, more than 50% of Fidelity’s $9.8 billion in revenue was generated by administering 401(k) plans and other employee benefit services for about 11,000 companies, including Philip Morris, Shell, IBM, Monsanto and Ford.

Those running the mutual funds know that if they rock the boat they jeopardize their chances of getting the contracts for these services. So, with ownership essentially AWOL, irresponsible corporate execs have been allowed to run wild. Not surprisingly, mutual funds have consistently refused to disclose how they vote. As California Treasurer Phil Angelides told me, “That silence speaks volumes.”

With their financial clout, if mutual funds demanded change, they would not--could not--be ignored. In fact, they could have insisted on and gotten all the rules and standards the new corporate reform law imposes. And much, much more.

And it’s not as if there are no role models. Take the example of Bill Gross, founder and managing director of Pacific Investment Management Co., or Pimco, which manages more than $250 billion in bond funds. This spring, after Gross took General Electric to the woodshed for misleading investors about the company’s debt, he unloaded most of Pimco’s $1 billion in GE bonds.

“I picked on GE,” Gross told me, “because I wanted to alert the investment universe that it wasn’t just Enron, Tyco or WorldCom pulling some fast ones, but GE--the biggest guy on the block--and probably everyone in between. GE definitely changed things in the last six months, and I sort of think I nudged them along the way.”

He didn’t just nudge it. He wounded it enough to force it to clean up its balance sheet. Gross’ speaking out was as remarkable for its effectiveness as it was for its rarity.

To see how an investment fund that doesn’t have its hands tied by conflicts of interest might operate, take a look at the nation’s largest pension fund, the California Public Employees’ Retirement System, or CalPERS, which gets its money directly from the state of California. CalPERS has announced that it will not do business with any bank that breaches the wall between research and banking, and it is considering Angelides’ proposal that it divest any company that has moved offshore to avoid paying taxes.

The debate over the last few months has focused on accounting firms mixing auditing with consulting and investment banks not keeping research independent of banking.

It is now time to hold mutual funds accountable: Isn’t their fiduciary obligation to their investors paramount? Or are they using the money of working Americans as a come-on to generate more servicing fees?