It's Time to Close the Door on Invesco

Investors should consider selling their holdings in Invesco Funds.

The securities and consumer fraud charges recently filed against the firm and its chief executive officer by state and federal authorities are more demerits for a fund family that has been in decline. Even before it was implicated in the widening mutual fund trading scandal, Invesco had been struggling with poor performance, significant manager changes, a massive restructuring, and rising expenses. Learning that the fund family accommodated market-timers in the face of evidence that the rapid trades may have impeded portfolio managers and harmed long-term shareholders convinces us Invesco's U.S. mutual funds don't deserve investors' money.

Before selling, fund investors should be sure to consider potential commission and tax costs of any trades. In addition, participants in 401(k) plans should be careful before dumping a fund if it is their only way to access an important asset class.

A Special Situation
The charges against Invesco are grave, but they're also different from those leveled at other large firms, such as Putnam Investments and Pilgrim Baxter & Associates. Authorities haven't accused Invesco managers of rapidly trading their own funds or firm executives of directly enriching themselves through improper trading relationships. Rather, Invesco was the first company to get into trouble solely for the way it interpreted and enforced its own prospectus. The fact that Invesco and its corporate parent Amvescap (AVZ) have asserted they did nothing wrong and have vowed to fight the charges and defend the implicated executive also sets this situation apart.

The complaints filed by New York Attorney General Eliot Spitzer, Colorado Attorney General Ken Salazar, and the Securities and Exchange Commission say that from at least July 2001 to October 2003, Invesco made exceptions to its prospectus policy on trading for certain large clients without telling its funds' owners or independent directors. Meanwhile, it rousted other investors who tried to market-time its funds without the firm's approval and promoted long-term investing in its marketing materials and shareholder reports, according to the complaints.

The timing arrangements went right to the top, authorities say. Executives such as chief executive officer Raymond Cunningham, chief investment officer Tim Miller, senior vice president of sales Tom Kolbe, and "timing police" chief Michael Legoski allegedly helped develop a policy for letting clients with $25 million or more in assets exceed the firm's trading restrictions, the complaints say. Authorities also allege that Invesco referred to these customers as "Special Situations" and the firm's policy toward them eventually included rules for "sticky money," or "money that the Special Situation places in (Invesco) funds and is not actively traded."

Between July 2001 and October 2003, Invesco let more than 60 brokers, hedge funds, and advisors rapidly trade at least 10 of the family's funds, the complaints say. At any given time market-timers accounted for up to $1 billion of the fund group's assets, according to the complaints. The complaints say one of the largest Special Situations was the infamous Canary Capital Partners LLC, which in September paid $40 million to settle charges of improper mutual fund trading brought by Spitzer.

Invesco denies it ever sold market-timing privileges for sticky assets, but doesn't dispute it allowed market-timers into its funds. Indeed, Invesco portrays its decision to open its doors to timers as an effort to protect its long-term shareholders. The firm has argued it was better off striking deals with large market-timers and setting limits on their trading than leaving itself at the mercy of "uncontrolled short-term traders who would go in and out of the funds when they chose." The firm argues its funds' prospectuses allowed them to modify its policy limiting investors to four trades per year as long as the change was in the best interest of the fund and it notified fund owners of alterations that affected all shareholders 60 days before the exemptions took effect. Since the firm allowed only some investors to market-time, technically the Special Situations didn't affect all shareholders and didn't require notification, Invesco officials argue.

We're suspicious of such legal hairsplitting. Given the evidence in the complaints, we're also skeptical of claims that a certain amount of controlled market-timing was good for long-term shareholders. The e-mails and memos cited in the complaints paint a picture of a firm that knew it was pushing the boundaries of its own policies and of what was good for shareholders.

One June 2002 memo stated, "This type of activity is not in the best interest of the other fund shareholders." Later, in a December 2002 memo, Invesco compliance officer James Lummanick wrote the trading policy exceptions "may be considered contrary to the prospectus disclosure. The level of market timing is not in the best interest of the non-market-timing shareholders, nor have they been provided notification of the change in policy 60 days in advance. Invesco Funds Group may be incurring business risk by continuing this market timing practice."

Other documents in the complaint cast doubt on Invesco's claims that it was able to control the market-timers it allowed in its funds. In a February 2003 e-mail discussing the activity of Canary Capital,  Invesco Dynamics  manager Tim Miller groused, "These guys have no model, they are day-trading our funds, and in my case I know they are costing our legitimate shareholders significant performance…. This is not good business for us and they need to go."

But despite the concerns, Canary didn't go, according to the complaint. Invesco allowed the hedge fund to continue trading, albeit at a reduced level.

A Mile High and Falling
The charges have hit Invesco in a weakened state. The family that was one of the fastest-growing fund firms of the late 1990s has faltered in recent years. Eye-popping returns from aggressive-growth funds such as Dynamics and sector offerings, such as  Invesco Technology (FTCHX) and  Invesco Health Sciences  helped the family grow from $9 billion in 1995 to $39 billion by August 2000. By the end of the decade, its stature was gaining on cross-town rival and bull-market darling Janus. In 2001 Invesco paid $60 million for the naming rights to the Denver Broncos' new football stadium.

The firm had started to lose altitude before Invesco Field at Mile High even opened, though. The bear market that began in March 2000 savaged the family's stock funds and many of them have lagged their peers in this year's recovery. Through Dec. 3, 2003, more than 85% of Invesco funds trailed their respective category averages over the previous 12 months. More than 80% lagged their typical peers over the trailing three years, and more than 70% plodded behind their average competitors over the trailing five years.

The fund family also has endured management turnover and corporate upheaval. Some departed managers, such as former  Invesco Growth  manager Trent May, had dismal records and probably deserved to go. But the firm has also lost some veteran hands in recent years, such as  Invesco High-Yield's  Jerry Paul, who was Morningstar's 1999 Fixed Income Manager of the Year; and  Invesco Core Equity (FIIIX) manager Charles Mayer, who had about three decades of experience. Currently the managers of two thirds of Invesco funds have less tenure than their average category peers do. This year's sweeping consolidation of  Amvescap's (AVZ) Invesco and AIM fund families, which merged 14 Invesco funds out of existence, adds to the confusion.

On top of all this, the expense ratios of many of the firm's funds have also increased in recent years as assets have declined. The family opted to keep 12b-1 fees, which are supposed to pay for fund marketing and distribution, on the no-load investor share classes of its funds after those shares closed to new investors in March 2002 when Invesco transformed itself into a broker-sold fund family. Rising expenses and keeping distribution fees on closed share classes isn't unique to Invesco, but it doesn't make the family any more appealing, either.

Invesco has fallen so far that a screen of Morningstar's fund database searching for Invesco offerings that meet a few basic qualities often used to describe good funds--above-average manager tenure and category performance rankings; and below-average expenses, turnover, tax costs, and volatility--currently eliminates all funds.

Hard Times in the Rocky Mountains
Invesco is the first fund company implicated in the scandal to stand up and mount a vigorous defense. It says market-timing isn't illegal; that all fund families struggle with rapid traders; that regulations on the practice are murky at best; and that Invesco was helping shareholders by making exceptions to its trading policy. Further, Invesco officials say now that the firm is essentially part of the AIM Investments, AIM's trading policies apply to Invesco funds.

We're wary of these arguments. Several firms operating under the same regulatory structure as Invesco, such as Vanguard and First Pacific Advisors, have decided that while not illegal, market-timing isn't in the best interest of their shareholders and have taken resolute stands against the practice. They may still struggle with timers, but they have decided it is better to establish and consistently enforce clear policies against the timing than to make exceptions on a case-by-case basis. We doubt doing otherwise helps long-term shareholders.

It's also not clear if following AIM's policies will make any difference. Invesco's most recent prospectuses include new, more detailed language on market-timing, saying it will monitor trading, limit exchanges, and use redemption fees and fair value pricing to discourage it. But the document seems to grant a lot of wiggle room, stating the family "reserves the discretion to accept exchanges in excess of these guidelines on a case-by-case basis if it believes that granting such exceptions would be consistent with the best interests of the shareholders."

Invesco will have its day in court, but in the court of public opinion it bears the burden of winning back investor trust. It isn't clear Invesco sold market-timing capacity for sticky assets (an indefensible practice in our view), and the firm contends its "special situations" were technically legal. Still, there is evidence that the firm had something other than its fund shareholders' best interest in mind when it allowed market-timing. Invesco CEO Cunningham himself admitted in an e-mail cited in the complaint that the firm was "constantly trying to balance revenue growth with an accommodation for this type of business." In the same message CIO Miller is described as someone who "has always been willing to work with timers as a group."

As it stands now, long-term investors have a choice between firms that are willing to man the battlements and fight the good fight against market-timing (they are out there), or an outfit that thought letting the Trojan Horse in the gate was a good idea. As long-term investors, we'd rather cast our lot with the former than with the latter.