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Rekenthaler Report

Private Funds: An Ongoing Danger

The benefits of keeping investment executives on a tight leash.

Illustrative photograph of John Rekenthaler, Vice President of Research for Morningstar.

Rotting at the Head

Investment funds are a form of socialism. Investors pledge common cause, in the belief that banding together is better than operating alone. Owning investment funds does not satisfy the strict definition of socialism, which requires state ownership of production, but it accords with less formal uses of the term.

By now, we all know socialism’s fatal flaw: the temptation that it presents to its leaders. Even group efforts need people in charge, executing the decisions. With socialism, those people possess far more clout than they otherwise would. The danger with socialism comes not from the collectivists themselves, but instead from those who supposedly work in their interests.

Which brings us to the topic at hand: investments. Mutual funds, exchange-traded funds, and private funds share the same underlying structure. Collectivists send their assets to a management team, which is tasked with carrying out their wishes honestly and appropriately. In theory, those managers treat those monies as if they are their own. In practice, unfortunately, that is exactly what some managers do.

For Example

Such was the case with MJ Capital, a Florida-based investment organization. Per the SEC’s complaint in August, MJ Capital and its affiliates, known henceforth as the MJ Companies, promised to spend investor assets on loans to cash-strapped companies, in exchange for a portion of those businesses’ future income. (It is not clear if investor returns were to be calculated from a single pool, multiple pools, or even individually, but whatever the details, this effectively was a private fund.) As lies went, that was a whopper. Over a 15-month period, the MJ Companies wheedled $196 million from prospective shareholders. They invested … $895,000, the complaint says.

The MJ Companies did, however, pay their salesforce “at least $61.8 million,” which amounted to more than 30% of their receipts. Talk about a high commission! MJ’s principals also pocketed $7.4 million of investor contributions for themselves, according to the complaint. Finally, the SEC says the fund’s managers distributed $109 million of their proceeds to investors—payments that merely represented the return of capital, but which management alleged were investment profits.

Public Funds’ Advantages

In short, the MJ Companies conned their customers. Thanks to two protections contained within the Investment Company Act of 1940, which regulates publicly registered funds, they could not have behaved similarly with either a mutual fund or an ETF. Those provisions are:

1) Realistic promises

According to the SEC’s suit, the MJ Companies claimed that their investments would earn 10% to 15% per month. (That 15,400 prospects bit on that absurd lure—akin to a fish swallowing a baby surfboard—is a testament to the great forces of greed, investment ignorance, and a highly motivated salesforce.) Public funds cannot make similar assertions, as the SEC, either directly or through its Financial Industry Regulatory Authority affiliate, strictly monitors their advertisements.

At times, the regulators are perhaps overzealous. Back in the day, the SEC banned Treasury funds from using the phrase “government guaranteed,” even though those securities were backed by the U.S. government, because the agency believed that those words implied that the funds’ prices could not change. More recently, the commission has suggested policing the terms “growth” and “value.”

That strikes me as a step too far. But better, I suppose, to err on the side of caution than to pursue investment firms after the damage has been done.

2) Public filings

Mutual funds must disclose their portfolio holdings quarterly, and most ETFs more often, at least daily. (Active nontransparent ETFs being a notable exception.) Private funds face no such requirements. Shareholders therefore cannot know if their funds are delivering on their word. (Even if thoroughly conducted, audits do not necessarily reveal when portfolios fail to match marketing’s blandishments.)

The public filings attract a spotlight. Through them, third-party organizations—including but certainly not limited to Morningstar—can spot when funds fail to match their prospectuses’ promises. The fund sponsor therefore need worry about more than the scrutiny of its shareholders, who, as we have seen, are not always attentive. Its actions may be noticed elsewhere, too. The electronic trail is visible for all who care to follow it.

Aside from these stipulations, public funds are covered by various additional safeguards, including mandates that investor assets be held in custody by an outside company, regular audits, and oversight from a board of directors, at least 40% of whom must be independent. While private funds observe the first requirement (and usually the second, although not the third), they have more opportunity to cut corners, should they so desire. For example, Bernie Madoff arranged sham audits for 18 years without anybody discovering otherwise.

Two Aphorisms

Earlier this year, the SEC recommended various reforms for private funds. While laudable, the commission’s proposals address neither of the aforementioned differences. Private funds may still market aggressively, establishing customer expectations that will be difficult—and in some cases, impossible—for the funds to meet. And although the SEC’s new proposal would require them to provide quarterly statements, those statements need not include portfolio holdings.

Ronald Reagan famously said, “The nine most terrifying words in the English language are, ‘I’m from the government, and I’m here to help.’” That lesson surely applies to funds, both public and private. When possible, the government should avoid regulating investment activities. Some securities are too illiquid to belong in public funds, and some strategies too risky (such as highly leveraged portfolios), but in general, the marketplace should determine the investment practices.

However, when it comes to overseeing the activities of fund executives, another maxim from the former president applies: “Trust but verify.” President Reagan used that precept when considering the promises from socialist leaders, who had gained their power by acting on behalf of others. Sound familiar?

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.