Fed To Reserve Funds: Drop Dead
November 6, 2008
By Max Rottersman

HANOVER, NH (ETFguide.com) - You don't need a CPA, CFA or MBA to assess the health of your money market fund. As long as you receive prospectuses the size of chemistry textbooks all is well. But when Reserve filed a one-pager on September 16th, shareholders learned an important lesson. When a mutual fund goes bad you're left in the dark while the lawyers soak up your fund fees fighting it out in court. Gone are the days when your fund manager waxes eloquently on your fund. All you're left with is silence and frustration. 

What's a shareholder to think, six weeks later, when Reserve's management says the fund is worth 97 cents but only gets 50 cents. It's a "smokescreen" one shareholder tells me. He wants to know why the fund couldn't sell its short-term assets and pay everyone off within weeks. He wants to know why the SEC has kept him in the dark. What are the implications, he asks, for a three trillion industry when a founding member can't meet its obligations.  

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When Lehman told the SEC and Fed it was going under, the government must have known about the soon-to-be-worthless Lehman paper. When tens of billions of dollars began leaving the Reserve fund, either immediately after, or just before, everyone must have known the smaller shareholders would suffer. Why, weeks later, did banks receive billions of dollars while small shareholders are still waiting to be made whole from a comparatively small $785 million problem? (Yes, I know some banks dug into their own pockets to make their money market shareholders whole, but they also got hefty injections of bailout money).

Can we speculate that no one at the SEC or Fed has the power to dispense money but Henry Paulson? Aren't the assets of Lehman also like everything else the government keeps telling us will come back in value later? Why can't the government front the $785 million and get it later, as it plans to do with the other debt? Why is it harder and harder to give the government the benefit of the doubt when it comes to, well, quite a simple thing: the fair distribution of financial help. 

What can we learn about Reserve management?

Bruce R. Bent is the Chairman, President, Treasurer and Trustee of the Reserve Funds. At age 71, he is joined by his two sons, Arthur, age 40, and Bruce R. II, age 42, who are each Co-Chief Executive Officer, Senior Vice President and Assistant Treasurer. Until April of 2007, the board had only two independent trustees, Edwin Ehlert, Jr. and William Montgoris. 

In late 2006, Reserve filed this with the SEC:

The Board of Trustees and shareholders of each fund listed below approved an increase in its management fee by one basis point (.01 of 1%) and the distribution and service fee by five basis points (.05 of 1%) of each applicable fund and each applicable class. In approving the fees, the Board of Trustees and shareholders of each fund also approved an amendment to the applicable Investment Management Agreement to exclude from the comprehensive fee the expenses of the services of each fund's compliance officer and independent counsel to the Independent Trustees which will now be paid by the funds

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The answer to why Reserve increased its fees is unclear. In 2005, management fees totaled a hefty $80 million. Even assuming a modest 20% profit margin, the Bent family should have been earning $16 million in profits.  

Months after the board approved the fee increases, the funds added five more trustees, ranging in age from 47 to 60 and with compensation between $16,000 and $89,000. The funds total board fees, now having their legal fees paid by the fund shareholders, rose from $298,000 to $719,000, of which only $382,000 was direct compensation to the trustees.  

If Reserve, as a shareholder lawsuit claims, deviated from its stated investment objective by sacrificing preservation of capital and liquidity in pursuit of higher yields all eyes will focus on the board of directors.  

Chairing the audit committee, William J. Montgoris appears to be the lead trustee, though he isn't given that designation. I was curious why Mr. Montgoris would allow the board to be expanded without increasing his compensation. Few directors give up power or influence without something in return. I then read on the Forbes site that Mr. Montgoris is on the boards of OfficeMax, Carters, and Stage Stores. His compensation from those boards totals $430,648. His biography in the Reserve prospectus reads, Retired since 1999; Chief Operating Officer of The Bear Stearns Companies, Inc. from 1979 to 1999; Director of Stage Stores, Inc. (retailing) since 2004. Trustee of other Reserve Funds.  

An interesting aspect is Mr. Montgoris' former connection to Bear Stearns. One would think he would be very sensitive to the risk of investing in Lehman paper especially after the Bear Stearns failure. But hindsight is 20/20 and maybe he wasn’t wearing his glasses.

Although Reserve manages 23 portfolios, 90% of their assets under management is in the Reserve Primary Fund and the Reserve U.S. Government Fund. Each fund has 11 classes, ranging from 0.13% in management fees to 0.81%. Both funds collect 12b-1 fees from retail investors. In 2005 the Pimary Fund collected management fees, on average, of 0.37%.  In 2008 it averaged down to 0.26%. 12b-1 fees also dropped from 0.07% to 0.04%. Reserve will probably use these facts to claim caveat emptor. The funds grew primarily from big institution money.  

There are thousands of money market funds. It's a hyper-competitive field. It's not impossible that Reserve was just smarter than everyone else; that they were able to maximize every extra penny of return. Whatever they did, to add another $100 million revenues in the arcane money market industry is an amazing accomplishment.

The smoking gun, however, is out in the open. The Primary fund grew, in two short years, from $20 billion to $64 billion, a growth of 319%. For that fund alone, management fees grew from $63 million to $109 million, an addition of $46 million. Reserve grew the sum of all its management fees from $80 million in 2005 to $180 million in 2008.  

The cautionary tale for ETF investors is this: In the one-page letter to shareholders Reserve claimed that paper with a face-value of $785 million had defaulted bringing the NAV down to 97 cents. Doing some simple math one realizes that 3% off $63 billion is more like $1.9 billion. Did other investors get out first?  Did $40 billion leave days before the Lehman paper was written off? If so, did they have inside knowledge? In any case, even if management had been able to save $200 million in the past two years it could not have brought the NAV back up to a dollar.  

Did the government turn its back on a small family run business in deference to publicly run companies?  

If a swap, or any counter-party derivative goes bust in an ETF, will the manager have the money to make the shareholders whole, especially in these days of extreme volatility? What would happen to today’s popular funds that make liberal use of swaps and derivatives like the UltraShort S&P 500 ProShares (AMEX: SDS), UltraShort QQQ ProShares (AMEX: QID), or the UltraShort Financials ProShares (AMEX: SKF)? Would the only help for blindsided shareholders come from the government via a bunch of SEC staffers sitting around their office watching the place burn down?

Max Rottersman is a partner of Hanover Technology Group, LLC. His opinions don’t necessarily represent the views of ETFguide.com or Yahoo Finance.