Mutual Funds: In the Scandals' Wake, A Raft Of New Rules

It's a tricky time to be in the mutual-fund business. Far-reaching scandals have ensnared some of the best-known fund groups, including Janus Capital Group (JAWS ); Putnam Investments (PEYAX ), a unit of Marsh & McLennan (MMC ); and Strong Capital Management. At least 16 mutual-fund companies, 12 brokerage firms, four banks, and dozens of individuals have been implicated so far, and analysts predict the scandal will continue to spread.

With the $7 trillion fund industry under intense scrutiny by regulators and legislators, a significant overhaul of the way funds do business is expected. This year should see new rules on trading, redemptions, fees, disclosure, boards of directors, and more. Those sweeping changes could have a profound impact on companies' bottom lines. "We could see some margin compression in 2004 due to changes in regulation and legislation for the industry," says Kenneth Worthington, a financial-services analyst at CIBC Oppenheimer.

Already, Alliance Capital Management Holdings LP (AC ), one of the firms under investigation, has agreed to cut fees by 20% on its stock and bond funds as part of its settlement with regulators. There is little doubt that industrywide reform of fees will follow.

The heavily tarred fund families continue to face other pressures, too. Case in point: Putnam, which in November saw outflows of more than $32 billion, or almost 12% of the money it manages, as major pension funds bolted. Every $5 billion less in assets at Putnam could cost about a penny per share in earnings to parent Marsh & McLennan, analysts say.

Now, the fund industry is dividing into a world of haves and have-nots. T. Rowe Price Group Inc. (TROW ), which hasn't been tainted, has seen its stock rise by 6% since the scandal broke in early September. Janus, meanwhile, lost almost 5% during the same period. "If you've stumbled here, it's going to take a very long time to rebuild your reputation," says Don Phillips, president of fund-rating service Morningstar Inc.

There is some good news for the industry as a whole. First, fund performance is stellar. The average U.S. equity fund gained more than 30% in 2004 through Dec. 26: "It could be a big enough windfall to overcome even a significant cut in fees of over 20%," says James Lowell, editor of Fidelity Investor, an independent newsletter.

Equally important is that even with the constant barrage of some funds' bad behavior, the public continues to invest. Roughly $64 billion has flowed into funds since the scandals hit. Investors aren't just pouring money into stock funds; they are also buying bond funds as well as niche fund products that combine equities and fixed-income for retirement plans. It's a trend that is expected to continue. "As the economy recovers, investors are going to earn more and save more," says Henry H. McVey, a financial-services analyst at Morgan Stanley.

That's why analysts aren't dismissing fund-company stocks altogether. "Managers will have to operate more stringently and efficiently," says Bjorn Turnquist, director of research at SNL Financial in Charlottesville, Va. "But if the market is going up, these companies will do well." After all, while investors may have been put off, they haven't been paralyzed.

By Lauren Young in New York, with Mike McNamee in Washington

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