As President Bush laid out a tough new stance last week on the increasing number of accounting scandals that plague Wall Street, fund executives turned their attention to accounting practices. Many executives said that portfolio managers have been too lazy about assessing the risk involved with the stocks they choose.
In fact, if portfolio managers spent as much time analyzing risk as they do performance, they might have avoided the stocks of such firms as Enron, Worldcom and Merck, executives said.
Peter Doyle, the CEO and chief investment strategist for Kinetics Asset Management in White Plains, N.Y., chalked the problem up to "widespread laziness in the industry."
"A lot of times the level of detail work is not as high as it should be," he said. "Portfolio managers aren't doing their homework."
Doyle's comments came last week as Worldcom executives took fire during a congressional hearing for allegedly masquerading $3.9 billion in operating expenses as capital expenditures in an effort to boost the company's stock price. The company is now struggling to avoid bankruptcy. In addition, Medco Health Solutions, a unit of pharmaceutical company Merck, said last week that it reported $14 million in revenue that had never been collected. Those imbroglios added to a list of scandals involving Enron, Merrill Lynch, ImClone and others, which helped knock the Dow and the Nasdaq down last week to their lowest points of the year.
In response, President Bush last week vowed to do everything in his power "to end the days of cooking the books." During a speech in New York's financial district, he called for double prison terms for executives who engage in fraud and, among other measures, asked Congress for 100 new Securities and Exchange Commission officers as well as more than $100 million in additional funding for the SEC.
But as debate rages about an effective government solution, Doyle maintained that fund managers can avoid the fray by reviewing the documents, most notably the 10-K, that firms file with the SEC.
"You're supposed to read whatever legal documents are filed with the SEC and determine if the accounting procedures are appropriate based on everything you read," said Doyle, who added that his firm holds some Merck stock, but has been untouched by the other scandals. "If it's a case of complete fraud, or if it's too complicated, you can avoid it or hire a forensic accountant to do some work on it."
In cases of outright deception and fraud, few will be able to spot a looming debacle, Doyle conceded. But he said that personal experience shows how research can save fund companies a lot of trouble.
"We've avoided investments because it's become so convoluted we can't get our arms around it," he said. When Kinetics portfolio managers sense buying a stock "is more akin to speculation, [they] just avoid it," he said.
Chip Roame, a fund consultant with the Tiburon, Calif., firm Tiburon Strategic Advisors, said that it's easy to become a "Monday morning quarterback" in the wake of these kind of scandals.
"Some of these companies that have gone in the tank were big, well-established, strong companies a couple of months ago," Roame said. "They may have been imploding internally at the time, but there weren't many outward signs of that."
Still, Roame said that fund companies should hire teams of risk managers who search out suspect corporate statements among stocks that portfolio managers consider. That job title is totally absent from the roles of most firms, he said.
"Where is that guy? What's his role in the company? Where's the person who plays that more negative role?" Roame asked. "We don't have that disciplined focus around risk the way we do around returns."
In addition, Roame said that with millions of baby boomers nearing retirement, it is more important than ever that fund companies secure the assets of aging investors.
And while investors won't likely pull out of equity funds en masse as a result of these scandals, Roame said that they will become increasingly concerned about who is picking their stocks and how the process works. In light of that, he said hiring teams of risk-focused executives is "a relatively small cost for the upside." Not only can better risk controls improve performance but they can serve as selling points, Roame said.
That said, much of the fund industry appears to be watching the argument inside the Beltway closely and eagerly anticipating what kind of legislation may arise.
The Investment Company Institute issued a statement early last week saying that it supported calls for stricter accounting standards. ICI President Matthew Fink sent a letter to the Senate last week saying, "It is necessary to bolster the independence of the accounting standard-setting process, strengthen oversight of public auditing and increase the authority and resources of the Securities and Exchange Commission."
In addition, Portsmouth N.H.-based Citizens Funds issued a statement last week, saying Bush's plan "focuses too much on punishment and not enough on prevention."
The firm also said that Bush's plan does not do enough to ensure that corporate boards are independent of undue influence. "We believe the administration will need to get much more specific for it to be effective in really raising the bar on corporate responsibility," Citizens' statement said.