Backlash

Go ahead. Make my day.

Fed up with passively suffering years of weak stock markets, corporate scandals and Wall Street double-dealing, public pension fund officials are seizing the opportunity to be enforcers in their own backyards, firing ethically challenged money managers and mapping out new rules of engagement for sponsor-manager relations.

The backlash against errant money managers is broadening from its initial focus on Putnam Investments Inc. — among the first named in lawsuits in the 10-week-old mutual fund trading brouhaha — to other tainted companies, including Janus Capital Group Inc., Strong Capital Management Inc. and Alliance Capital Management LP.

Some see pent-up frustration adding an angry edge to that response. "What's going on now is a comeuppance," with people striking out in retribution for the market losses of the last three years, said Louis S. Harvey, president of Dalbar Inc., a Boston-based research firm that follows the industry.

Of course, more than vengeance is involved. Ralph White, a member of the Massachusetts Pension Reserves Investment Management Board — the first big state pension fund to pull money from Putnam last month — said terminating a manager that fails to keep its house in order is simply a matter of due diligence and fiduciary duty.

But politics is a big factor as well. With 95 million Americans investing in mutual funds and pension funds investing billions of dollars on behalf of millions more, the scandal has given state and municipal officials who dominate public fund boards ample opportunity to make hay out of the situation.

Recent developments suggest there will be a lot more hay to come by in the next few months, as high-profile heads keep rolling and regulators keep their subpoena mills running overtime.

Pilgrim Baxter & Associates founders Gary Pilgrim and Harold Baxter both left their firm Nov. 13 after conceding that Mr. Pilgrim had invested in a hedge fund that actively traded some of the company's funds, with Mr. Baxter's knowledge. On Nov. 20, the Securities and Exchange Commission and New York Attorney General Eliot Spitzer sued the pair and the firm they founded.

Other departures included John D. Carifa and Michael J. Laughlin, who headed Alliance's mutual funds business and fund distribution business, respectively, and Richard Garland, who ran Janus' international business.

Meanwhile, Massachusetts State Secretary William F. Galvin issued a new round of subpoenas to Boston-area fund giants, including Fidelity Investments and John Hancock Funds, and Mr. Spitzer promised that charges against other fund companies will be forthcoming soon.

That leaves some observers anticipating more money management scalps will be taken soon. There's "still public appetite for more burnings at the stake," said Dalbar's Mr. Harvey.

How the scandal unfolds from here may depend on whether pension officials are game to pursue an exhaustive witch hunt for managers found to have strayed from the fiduciary straight and narrow, or whether they'll follow the old Chinese proverb: "Kill one to warn a hundred."

Some pension executives expect the narrower strategy to prevail. "If you have two or three of these (tarnished money managers) in your portfolio, then firing them puts you in a tight spot" that entails a lot of work, said the executive director of a state fund with more than $15 billion in assets, who requested anonymity. How do you proceed "if everybody is a little bit guilty?" he asked.

In recent weeks, the list of money managers being terminated or put under review has expanded. For example, the $3.3 billion ChevronTexaco Corp. defined benefit plan, San Ramon, Calif., terminated Strong, which managed $50 million in a U.S. small cap equity portfolio, just months after hiring them. Batterymarch Financial Management has taken over the portfolio, according to sources close to the fund. Fund officials declined to comment.

But Putnam remained the focus of public pension fund ire, with institutional and mutual fund outflows totaling roughly $23 billion since the SEC and Massachusetts brought charges against the company on Oct. 28.

Putnam has assumed "poster-child status" for the mutual fund trading scandal — a dangerous place to be considering its extensive list of big public pension fund clients, said Don Phillips, a managing director with Chicago-based Morningstar Inc. The fact that its own portfolio managers were found to be market timing the funds they oversaw has left the company open to sharper criticism than firms that allowed outsiders to market time their funds, he said.

Last week's decision by the $155.5 billion California Public Employees' Retirement System, Sacramento, to fire Putnam as manager of $600 million in international equities and another $600 million in domestic equities was a case in point.

CalPERS officials were clearly taking a big-picture view of the situation, with Putnam cast in the role of "Exhibit A".

"We hope that the Putnam disaster will serve as a catalyst for major improvements in ethical behavior, internal controls and corporate governance not only at Putnam but throughout the industry," said Rob Feckner, chairman of CalPERS' investment committee.

Putnam's firing "sends a strong signal to the marketplace that there will be serious and immediate consequences and penalties to violating the trust we hold with investors and pensioners," said California State Treasurer Philip Angelides.

At the same meeting, CalPERS officials said they plan to introduce an "external code of ethics" in the next few months, which money managers hoping to serve the giant California fund will have to abide by. North Carolina state Treasurer Richard H. Moore detailed his own guidelines last week, including a demand that money managers agree to hold any shares they buy in their company's funds for at least one year, and that two-thirds of a fund's directors be independent.

Ironically, Putnam, in the partial settlement it reached with the SEC on Nov. 13, instituted that one-year holding period for its portfolio managers and called for a minimum of 75% of the trustees on the boards of Putnam mutual funds to be independent.

Putnam's moves have won the company kudos from both analysts and some pension fund trustees who had sharply criticized the money manager for its lapses.

Putnam has taken steps that should prove "very positive" for mutual fund investors, predicted Morningstar's Mr. Phillips.

MassPRIM trustee Mr. White — who had been one of the strongest voices at the PRIM meeting calling for Putnam's termination— also applauded the company's efforts. If Putnam had acted sooner to clean house, the $29 billion pension fund might have opted to just withdraw its $1 billion in international equities, where errant portfolio managers were found to be market timing their own funds, and left its $750 million domestic equity mandate with the company, he said.

During the first few weeks of Putnam's ordeal, Massachusetts was the only large fund to terminate a domestic mandate, allowing the company's executives to argue that Putnam's woes were confined to its international equity accounts where the market timing trades had taken place. But then the $7.8 billion Hawaii Employees' Retirement System took back $440 million in active domestic large-cap growth stocks on Nov. 7 "due to lack of disclosure and the way they mishandled the investigation" into market timing, said Kimo Blaisdell, chief investment officer. Last week, CalPERS struck as well, to the tune of $608 million in active U.S. growth stocks.

That strikes some observers as overkill. Said the executive director of a state pension fund with more than $15 billion in assets: "Yes, fire them for international, but firing them on the domestic side is purely political."

The groundswell against Putnam offers some support for the argument that pension fund officials are looking for an example rather than wholesale bloodletting. For example Morningstar, advising the retail investors who are ostensibly the prime victims of the market-timing scandal, judged Putnam's sins less harshly than other mutual fund advisers, including Alliance Capital's AllianceBernstein's unit, Janus, Strong and Bank of America's Nations funds. But big public pension funds that employed both Putnam and AllianceBernstein, including CalPERS, have seen fit to move against the former but not the latter.

Massachusetts officials, with the notable exception of Mr. Galvin, have welcomed the steps the company has taken since the money manager's parent, Marsh & McLennan Cos., installed a new executive lineup on Nov. 3.

Dalbar's Mr. Harvey said that's only prudent: For an elected official in the state, whipping Putnam for its transgressions wins votes, but hitting a big Boston-based employer so hard that it could be forced to shed employees is a way to lose office, he noted.

Other states, which don't have to worry about that angle, have less reason to hold back. Following the CalPERS decision last week, the Oregon Public Employees Retirement Fund, Salem, opted to terminate its $500 million international mandate with Putnam, while leaving Alliance, another company caught up in the trading scandal, on watch for its $3.6 billion in three equity portfolio and one bond strategy.

The $40 billion Washington State Investment Board, Olympia, on Nov. 21 terminated Putnam as manager of $585 million in international equities. The action "sends a clear message that the board has lost confidence in Putnam and establishes WSIB's expectation about what is unacceptable conduct, but not in a haphazard fashion," said Joe Dear, executive director, in a news release.

Kimberly-Clark Corp., Dallas, also terminated Putnam, which ran $246 million in active international equities for the $2.8 billion pension plan, said a company official. Neither the official nor Stephen J. Wagenbach, managing director at CRA RogersCasey, the plan's consultant, would comment on the termination.

The Milwaukee City Employees' Retirement System moved against the company as well last week, stripping Putnam of $277 million in international equities.

Morningstar's Mr. Phillips predicted that Putnam will survive the current squalls. The company's new chief, Charles "Ed" Haldeman, is a well-respected industry veteran who successfully turned around other money managers before coming to Putnam last year, he said.

"The political mindset is a short one," said Mr. Phillips. "Putnam just has to weather the storm and get through this."