DWS Funds Finally Clear Up Ethical Concerns

Many fund investors probably think that the market-timing scandal that first surfaced in late 2003 has been resolved for a good while. But that's not the case. In fact, Deutsche Asset Management, the advisor to the DWS Funds (known until recently as the Scudder Funds), settled with regulators regarding alleged market-timing arrangements on Dec. 21, 2006. That settlement comes nearly three years after the firm first disclosed it had an agreement with an investment advisory firm to market-time several of its foreign-stock funds--a revelation which spurred us to recommend that investors refrain from buying new shares of any of the firm's funds.

We are lifting that recommendation; we think DWS' funds can now be evaluated on their individual merits. As part of its agreements with the SEC and the office of the New York Attorney General, Deutsche agreed to pay a total of $122 million, which will be disbursed to the funds and shareholders of the affected funds through a distribution plan yet to be developed. The firm must also keep in place, for roughly three more years, fee cuts implemented two years ago, its fund boards must continue to be composed of at least 75% independent trustees (including independent chairs), and Deutsche must undergo a compliance review by an independent consultant.

Timing Timing Everywhere
While we're pleased to see Deutsche finally resolve its market-timing issues to the satisfaction of regulators, we're dismayed at the extent of the market-timing activity across the fund lineup, which was significantly greater than we had believed. Deutsche acquired the Scudder funds--which had merged with the Kemper funds in the late 1990s--in 2002, but already sold its own funds under brands such as Flag and Bankers' Trust. Timing took place across the legacy Deutsche, Kemper, and Scudder funds. Regulators found that there were 10 explicit timing deals--all of which originated before the Deutsche acquisition--in which market-timing activity was allowed in 22 funds in exchange for those investment firms placing "sticky" money (long-term investments, for example) in other funds, thus allowing the funds' advisors to generate fees. The trading in these deals amounted to more than $2.5 billion and caused $34 million in diluted returns for fundholders. There were many other instances of timing that stemmed simply from management's failure to enforce trading restrictions listed in the funds' prospectuses. In what may be the most egregious timing example, the portfolio manager for Scudder Small Cap Equity was, for a period of time in 2000, being swamped with $45 million to $50 million in trades per day from market-timers. (That manager no longer works for Deutsche.) And some of the timers were, in certain stretches, trading one or more funds on a nearly daily basis. Finally, the firm's disclosure of market-timing activity prior to the settlement left a lot to be desired; fund shareholders weren't informed of the timing deals at first, and only the aforementioned, single timing agreement was publicly disclosed at the outset.

Yet despite the extent of the market-timing that occurred across the DWS fund lineup, we're satisfied that Deutsche Asset Management, from an ethical standpoint, has become sufficiently trustworthy. The firm asserts that all personnel who were involved in the market-timing deals are no longer with the company. That's a credible statement, in part because of the substantial turnover we've seen within the firm's executive and portfolio manager ranks since the 2002 merger, and regulators' moves to force out employees who were involved. Beyond substantial personnel changes, the firm has hired an ombudsman to enable employees to raise ethics questions without fear of retribution from management, and it has markedly stepped up the monitoring of its funds for potential market-timing activity. All of these moves help reduce the possibility that the funds will again be timed.

The Way Forward
It's important to note that this is far from a blanket endorsement of the funds; our opinion of the DWS lineup is quite mixed. Furthermore, we'll continue to keep an eye on the firm's compliance procedures. But we believe Deutsche has cleared up concerns about its commitment to shareholders. We will be updating the DWS funds' Stewardship Grade texts in the near future to reflect the steps Deutsche has taken, but we don't expect to make substantial changes to their grades until this settlement is further in the past.