Vanguard's Bogle Says Thousands of U.S. Stock Funds May Close
By Joel Dreyfuss and Ed Leefeldt
New York, Aug. 23 (Bloomberg) -- The loss is staggering: From March 2000 to July 2002, the value of the U.S. stock market plunged by $3.7 trillion.
The bear grip will squeeze out the excesses in the U.S. mutual fund industry, says John Bogle, founder of Vanguard Group, the second-largest U.S. mutual fund manager, with $570 billion in assets. After a 28-month, 41 percent plunge in the Standard & Poor 500 Index, the $6.6 trillion fund industry is poised for a shakeout that could claim half of its 4,800 equity funds, he says.
While the S&P 500 has rallied 5.6 percent in August, its slump since March 2000 will also spur needed changes in the way companies manage and account for pension funds and stock options, investors say.
``The changes Wall Street faces are like a root canal,'' says Barry Barbash, who headed the Securities and Exchange Commission's investment division from 1993 to 1998.
Since 1990, the number of U.S. funds has soared to 8,325 from 3,679, according to the Investment Company Institute. Total assets under management rose to a peak of $7.3 trillion in March 2000 -- when the S&P 500 reached a record 1,527 -- from $1.1 trillion in 1990.
`Seminal Moment'
In July, investors pulled $31 billion out of U.S. equity funds, according to AMG Data Services, which tracks the fund industry. Money managers such as Putnam Investments, FleetBoston Financial Corp. and Merrill Lynch & Co. are starting to consolidate or close funds that have posted slack returns.
``This is a seminal moment for the industry,'' Bogle says.
Many of the funds that sprang up during the bull market -- much like the dot-com companies they invested in -- have never made much money for investors, says Russel Kinnel, director of fund analysis at Morningstar Inc., a Chicago-based research company.
``Obscure funds with huge losses and no assets will never rebound -- even in a rally -- but of the 100 biggest funds, very few will go away,''' he says.
Laggards
On average, U.S. stock funds posted annual returns of 10.8 percent during the 1990s, according to the Investment Company Institute, compared with an 18 percent average annual gain in the S&P 500.
Stock market losses have hammered corporate retirement funds too. The unfunded liabilities of U.S. corporate pension funds -- the difference between what companies expect to pay retirees and the amount of money they have on hand -- soared to a record $111 billion in December 2001 from $26 billion a year earlier, according to Pension Benefit Guaranty Corp., which insures pension plans for 43 million workers.
Billionaire Warren Buffett says companies need to curb unrealistic assumptions about their fund returns. Ford Motor Co., SBC Communications Inc. and Verizon Communications Inc. have said in SEC filings this year that they expect their funds to generate returns of 9 percent or better in 2002. Buffett called such forecasts ``wildly optimistic'' in a July 24 op-ed article in the New York Times.
Telecommunications companies such as SBC and Verizon used pension projections to pad reported earnings as much as 16 percent in 2001, says David Dixon, an analyst at BMO Nesbitt Burns Inc., a Toronto investment firm.
Topping Up
Now, the reverse may happen: Companies face the prospect of having to top up funds out of already-shrunken profits. Ford figures that last December, its pension fund had $600 million more than it needed to pay retirees, says spokesman David Reuter.
By June, the carmaker was short $3.2 billion, he says. So far, Ford doesn't expect to have to add money to its $33 billion pension fund until at least 2006, Reuter says. The automaker has no immediate plans to change its projection for its returns, he says, adding that the company's returns have averaged 10 percent during the past 30 years.
U.S. Representative George Miller, a California Democrat, has asked the Treasury Department to investigate whether companies have knowingly overstated pension fund returns to boost reported earnings. ``The failure to accurately account for their pension liabilities could cause them serious financial jeopardy,'' he says.
Transparency Push
Analysts say the bear market will accelerate the move away from accounting measures such as earnings before interest, taxes, depreciation and amortization, or Ebitda, and pro forma earnings, the latter of which S&P calls so vague they sometimes mean ``as if the company didn't have to cover proper expenses.''
S&P has begun calculating so-called core earnings for companies in the S&P 500 and 10,000 other public companies. The computation takes into account all revenue and costs associated with a company's main business, including employee stock options. It excludes revenue from secondary sources, such as investment gains and losses. S&P's method would have shaved 17 percent off the combined 2001 reported earnings of companies in the S&P 500, says Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School.
By early August, almost 40 U.S. companies -- including Bank One Corp., Coca-Cola Co., General Motors Corp. and Washington Post Co. -- committed themselves to subtracting the cost of employee stock options from bottom-line profits rather than relegating them to footnotes in financial statements the way current U.S. accounting standards allow.
`This Train Has Left'
Investors will demand the rest of corporate America follow suit, says James Dimon, chief executive of Bank One. ``I think this train has left the station,'' he says.
Bank One says the move will reduce its 2002 earnings by 2 cents a share. Coke says the change will cut 2002 earnings per share by 1 cent. Both companies say the impact will gain in future years, rising to 9 cents a share in 2006 for Coke. A wholesale change in options accounting would have sliced 12 percent off the reported earnings of S&P 500 companies in 2001, according to Bear Stearns Cos.
It's worth taking that hit because investors will place a premium on transparent financial reporting, Dimon says. ``This is reality,'' he says.
Felix Rohatyn, 74, former New York head of Lazard Freres & Co., says companies will have to struggle to regain the trust of investors. Enron Corp. executives have invoked their Fifth Amendment rights in appearances before congressional committees investigating the financial reporting that led to Enron's collapse.
On Aug. 1, Scott Sullivan and David Myers, former WorldCom Inc. executives, wore handcuffs as they ran a gauntlet of TV cameras. The Justice Department charged them with securities fraud for hiding $3.9 billion in expenses. The alleged fraud prompted WorldCom to file for bankruptcy in July. With $107 billion in assets and $41 billion in debt, the company was the largest in U.S. history to declare bankruptcy.
A Matter of Trust
``I don't think I've ever seen this level of concern or doubt about the quality of financials or the integrity of the structure of our financial system,'' says Rohatyn, former U.S. ambassador to France. ``The issue of fairness is going to remain.'' Ultimately, he says, the market will rise or fall on whether or not investors believe that corporate executives are telling them the truth.
``We need a cultural change, and it hasn't emerged yet,'' says Chuck Hill, director of research at Thomson First Call. ``There's no movement by corporate America to step up and do the right thing. It's all just legalese.''
In 1991, John Gutfreund's career as chairman of Salomon Inc. came to an abrupt end when the SEC ruled that he and two other Salomon executives had failed to promptly report misconduct by traders who had violated U.S. Treasury auction rules. Since then, Gutfreund, 72, now a senior managing director at C. E. Unterberg Towbin, has become an advocate of clear regulations -- and ethical behavior. ``I don't think the laws will change much,'' Gutfreund says. ``The spirit has to change.'' That will happen only if companies start to believe that honesty will add to their bottom lines. |
