Lying Van Kampen Mutual Fund Busted by SEC (Fool Plate Special) September 9, 1999

An Investment Opinion

Lying Van Kampen Mutual Fund Busted by SEC

By Louis Corrigan (TMF Seymor)
September 9, 1999

Hurrah for the Feds! The Securities and Exchange Commission (SEC) yesterday busted the Chicago-based Van Kampen Investment Advisory Corp. and its former chief investment officer Alan Sachtleben for lying to investors about how its then newly created Growth Fund managed its sizzling 62% return in 1996, walloping the market's 23% gain. This case highlights how the mutual fund industry often manipulates early performance results for its "incubator" funds so they can be aggressively marketed to the public. The case also appears to be part of a broader effort by the SEC to address the inadequate and often misleading performance disclosure by mutual funds both in marketing materials and in regulatory filings.

In 1996, the giant Van Kampen fund company injected its own cash to start up the Growth Fund with the goal of creating a one-year performance record that could be used to attract individual investors. The Growth Fund's market-crushing return made it #1 among diversified stock funds for the year, according to Lipper Analytical. That ranking enabled it to attract $109 million from nearly 15,000 public investors in the first quarter of 1997.

The problem is that Van Kampen failed to disclose that the fund's performance was boosted by hot initial public offerings (IPOs) that year -- 31 to be precise. The fund picked up merely 100 to 400 share lots of each new issue. Still, the incubator fund was then so small -- just $200,000 to $380,000 in assets -- that these tiny IPO stakes had a dramatic effect on the fund's performance. Indeed, the SEC determined these investments accounted for more than half the fund's stellar return for the year.

As a mutual fund's assets grow, however, such IPO shares inevitably have a declining impact on the portfolio's overall performance because the firm just can't get its hands on enough shares to boost returns significantly. Moreover, such returns have little or nothing to do with the investment prowess of the money managers. So these results were clearly unsustainable.

More important, Van Kampen's Sachtleben knew this. The SEC determined that in early 1997, Sachtleben conducted an internal study that determined that IPOs accounted for a third of the Growth Fund's 1996 return. Yet he failed to tell the fund's Trustees or other senior Van Kampen officials. As a result, neither the marketing materials nor the regulatory filings disclosed this fact. Indeed, when's reporter Alex Berenson raised questions about the fund's results in late 1996, he was flat out lied to. Van Kampen spokesperson Michael Kollins said at the time, "It's not as if the fund has had a bunch of hot IPOs."

Thus, public investors had no way of knowing they were being duped into thinking that the Growth Fund's portfolio managers were geniuses. And they clearly weren't. Data from Morningstar reveals that the fund has badly underperformed since it was opened to public investors in 1997.

In yesterday's press release, SEC Enforcement Director Richard H. Walker said, "This enforcement action -- the first of its kind -- demonstrates that it is wrong to raise shareholder expectations of future gains by advertising spectacular past returns when it is highly unlikely those returns can be sustained as the fund grows in size."

While neither admitting nor denying the charges -- legalese for "you got me, let's settle" -- Van Kampen and Sachtleben accepted fines of $100,000 and $25,000, respectively, and agreed to stop violating the securities laws' antifraud and reporting provisions. Of course, the unnamed culprits here are the fund's Trustees, who are akin to a corporation's Board of directors in that they have a fiduciary obligation to oversee how the fund is being managed and whether sufficient information is being disclosed to public investors. Too often, though, such Trustees merely cash their checks and call it a day. That's got to change.

The Van Kampen case is a shameful one, but not surprising given the competitive asset management market. Still, it's exactly the kind of story that helps explain part of the Fool's skepticism regarding the fund industry, which over over-promises and underperforms.