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Mutual Fund Investigations

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Mutual Fund Investigations

  1. 1. Catalyst FPIM, Inc. 1 Mutual Fund Investigations Morgan Stanley: Updated 11/19/03 What has occurred? The S.E.C. charged Morgan Stanley with sales and disclosure violations by their brokers. MS brokers selling mutual funds directly to retail clients were accused of not disclosing that they would receive greater compensation from selling Morgan Stanley funds or certain funds in MS’s “Partners Program.” Also, MS brokers had a high proportion of sales of B-class shares. The S.E.C. claimed that brokers did not properly explain the costs of different share classes, and that brokers would often make more money selling B-class shares in the long run, then they would selling the up-front sales charge A- class shares. There are no current allegations regarding trading in the mutual funds themselves. What is the company doing? Morgan Stanley has reached a settlement regarding the civil charges by the S.E.C. Without admitting or denying wrongdoing, the company has agreed to pay $50 million to reimburse clients affected by their sales practices. MS will also allow clients to switch out of inappropriate fund shares. The company will adopt enhanced disclosure policies written in plain English, retain an independent consultant to review disclosure adequacy in the Partners Program, and will no longer accept “soft dollar” payments for retail distribution of other firms’ mutual funds. Is there a possibility of impact on the performance of funds that Catalyst uses in client accounts? All three Morgan Stanley funds used in Catalyst client accounts – Morgan Stanley Institutional US Real Estate A, Morgan Stanley Institutional International Equity and Morgan Stanley Institutional Muni – are institutional class funds that carry no fees other than annual fund operating expenses. Any outflows from the other share classes of these funds would not affect the institutional class.
  2. 2. Catalyst FPIM, Inc. 2 MS Ins Int’l Fund is, as it has been all year, underperforming the MSCI EAFE index. However, in the past 3 months and 1 month to date the margin of underperformance has decreased. MS Ins US Real Estate Fund is outperforming its index on a year-to- date basis and 3 months to date basis, and slightly underperforming on a 1 month to date basis. MS Institutional Muni is in the top 1% of its category for the 12 month, 3 year, 5 year and 10 year time periods as of 9/30/03. Current return year to date return is 4.511%, but index comparisons for the same period are not available. What is our position to date? Since Morgan Stanley’s problems are currently exclusive to their in-house brokers’ sales practices, we are comfortable retaining the funds we use in client accounts. Should there be further disclosures regarding mutual fund trading practices, we would re-evaluate our position at that time. Janus Capital: Updated 11/19/03 What has occurred? Janus Capital was one of the three companies named in the New York state attorney general’s original complaint against Canary Capital Hedge Fund. It alleged that Janus allowed the fund to engage in market timing in some of its funds, granting it special trading privileges in exchange for other Canary investments that would increase fee revenues for Janus. The funds Janus allowed market timing in were the Janus Mercury and Janus High Yield funds. The funds used by Catalyst were named Berger Mid and Small Cap Value prior to May 2003; they were not Janus funds and are managed by Perkins, Wolf, McDonnell & Co., based in Chicago. Stillman Financial owned Janus Capital, Berger Funds and several other money management firms. In May, Janus Capital took over the marketing and administrative duties for the Berger and other firms; at that time they took on the Janus name. They were not involved in any of the market timing alleged in the complaint. The Janus Small Cap Value Institutional was (and is) closed to new investors.
  3. 3. Catalyst FPIM, Inc. 3 What is the company doing? Janus Capital has instituted an internal review of the allegations. Employees involved in the decisions to allow market timing have left the company, most notably the CEO of Janus International. The investigation to date indicates that: none of Janus’ current portfolio managers on the affected funds established the market timing arrangements; no portfolio manager or senior executive engaged in frequent trading for their own account; Janus has no agreements allowing investors to buy shares after market close and no evidence has been found that this occurred. However, much trading in Janus funds comes through intermediaries and not directly through Janus. Janus’ investigations will continue. Janus is cooperating with the NY Attorney General’s office and the S.E.C. and is in preliminary negotiations to resolve the issues. Janus has also hired a former director of the S.E.C.’s Division of Investment Management to review company policies and implement new business practices. The short-term redemption fees charged in 14 Janus funds on amounts sold within 90 days will be raised from 1% to 2%; short- term redemption fees are being considered for many other Janus funds. Janus will also increase the frequency of disclosure of mutual fund portfolio holdings from semi-annually to monthly which will increase transparency. Janus is contributing the fees it earned on the market timing arrangements to the impacted funds. Is there a possibility of impact on the performance of funds that Catalyst uses in client accounts? Janus Capital, as a whole, has experienced net outflows from its mutual funds. Since September 30th investors have pulled out $3.3 billion during a period that had net inflows into all equity mutual funds. The funds managed by Perkins, Wolf, McDonnell & Co. (Janus Mid Cap Value & Janus Small Cap Value) experienced net cash outflows in September (the month the scandal broke), but these amounts were not significant. Morningstar® advised its subscribers to consider selling funds managed in-house by Janus, but specifically exempted the Perkins funds and others managed by outside firms. Note that as of 12/31/02, Janus Capital managed about $140 billion in assets; the funds managed by Perkins total about $4.6 billion in assets.
  4. 4. Catalyst FPIM, Inc. 4 Janus Mid Cap Value Fund is outperforming its index on a year-to- date, 3 month to date and 1 month to date basis. There is no evidence that performance has slipped lately. Janus Small Cap Value Fund is underperforming its index on a year-to- date and 3 month to date basis, but is outperforming 1 month to date. Underperformance has been the result of managers investing in higher quality stocks that were out of favor in the first half of the year, and concentrating on downside protection in what they think is a momentum market that will cool in time. What is our position to date? The funds Catalyst uses were not involved in the market timing activity and were not even part of Janus when the activity occurred. The advisor to the Janus Mid and Small Cap Value Funds has demonstrated its commitment to its shareholders by closing the small cap fund to new investors in a “hard close,” i.e. independent advisors cannot add new accounts even if they have portfolios that already hold the fund. This indicates that the advisor was willing to forego additional fees that come with asset growth because they could not operate as effectively in their market and investment style will larger assets. Both funds have performed well, although the Small Cap Value is having a disappointing year. The fundamentals of the two funds do not warrant a sale; additionally, almost all of our accounts hold unrealized capital gains in these funds. That said, we will continue to monitor fund outflows from these funds; the Janus name may “tar them with the same brush.” Federated Funds: Updated 11/19/03 What has occurred? Federated began an internal investigation after the S.E.C. and the NY Attorney General subpoenaed the firm for information on trading irregularities. Neither organization has brought charges against the firm to date. What is the company doing? Federated released a statement on October 22, stating that it had found evidence of market timing and late trading in some of its funds. It is yet unclear how widespread this activity was, which funds were involved and who allowed it to occur. The company has not issued any further information to date.
  5. 5. Catalyst FPIM, Inc. 5 Is there a possibility of impact on performance of funds that Catalyst uses in client accounts? The only fund used by Catalyst is Federated Short-Term Muni Institutional (FSHIX). Its performance has been acceptable to date; until more information is forthcoming from Federated it is unclear whether this fund will be affected, although it is in an unlikely category to have been used for either market timing or late trading. What is our position to date? Our use of this fund is very limited, there are no unrealized capital gain exposures to speak of (since it is a short-term bond fund) and there are many alternatives that we can use to fulfill its purpose in an account (Schwab Yield Plus is one good alternative). Since there is no compelling reason to keep this fund, and the fund company has not offered much information, we will replace it with a suitable alternative as soon as possible. Charles Schwab & Co.: Updated 11/19/03 What has occurred? Schwab began an internal investigation after receiving queries from both the Securities and Exchange Commission and New York Attorney General Eliot Spitzer, and has disclosed it had found some instances of questionable trading at its U.S. Trust Co. subsidiary. The firm discovered arrangements with five institutional customers, which allowed them to market time the Excelsior funds, which are managed by U.S. Trust. The company also found 18 late trades, although it is not yet clear whether these were merely processing errors. What is the company doing? Two employees in the institutional mutual fund sales group at U.S. Trust unit were terminated for allegedly attempting to destroy documents related to the investigation. The company’s investigation continues. Is there a possibility of impact on performance of funds that Catalyst uses in client accounts? At this point, the irregularities
  6. 6. Catalyst FPIM, Inc. 6 were found in the Excelsior funds managed by U.S. Trust. Catalyst does not use any of these funds in client accounts. What is our position to date? Schwab’s internal investigation is in an early stage. We will continue to monitor developments. Managers Special Equity Fund: Updated 11/21/03 What has occurred? Managers Special Equity fund employs 5 money management firms to separately manage assets for the fund. One of the money managers, handling about $600 million of the fund’s $3.1 billion in assets, is Pilgrim, Baxter & Associates. Gary Pilgrim and Harold Baxter, the firm’s founders have retired from the firm, and have been charged by the New York Attorney General and the S.E.C. with civil fraud and breach of fiduciary duty. Specifically, Gary Pilgrim was accused of profiting from short-term trading of his firm’s mutual funds by a hedge fund in which he was a major investor. Harold Baxter was accused of giving nonpublic portfolio information to a friend who ran a small brokerage, who passed on that information to clients who used it to market-time the Pilgrim Baxter PBHG funds. These transgressions occurred in the mutual funds; the money managed for Managers Special Equity is a separately managed account and thus, could not be timed by other investors. However, the lead manager on this account was Gary Pilgrim. What is the company doing? The Managers funds were apprised of the situation by Gary Pilgrim the day before his retirement. The co- manager of the account, who has been taking on most of the day-to- day responsibilities of management in the last two years as part of a succession plan at the firm, will remain as the sole manager of the account. His name is Pete Niedland. The Managers Funds is conducting a search for a replacement manager (or managers) for this portion of the portfolio. Nothing will be done in haste, however, as the firm wants to follow all due diligence procedures to ensure a quality replacement. Is there a possibility of impact on performance of funds that Catalyst uses in client accounts? Since Pilgrim, Baxter manages part of Managers Special Equity Fund as a separate account, not as
  7. 7. Catalyst FPIM, Inc. 7 part of a mutual fund, there is no possibility of loss from market timing. What is our position to date? We will wait and see which manager is hired to replace Pilgrim, Baxter, and then re-evaluate the fund in comparison with other options.

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