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Commentary

The Other Shoe Drops at AllianceBernstein

As evidence and expenses mount, it's hard to recommend this firm.

It’s time to consider selling AllianceBernstein Funds.

Shortly after  Alliance Capital Management (AC) announced it had suspended a portfolio manager and sales executive for trading market-timing privileges in one of the firm’s AllianceBernstein mutual funds for long-term investments in the company’s hedge funds, we warned investors to limit their holdings in the family. We stopped short of the blanket sell recommendation we issued on other fund complexes implicated in the mutual fund trading scandal because, at the time, we had seen no evidence that members of Alliance Capital’s upper management were aware of the timing, or if there had been other arrangements.

We now know the answers to those questions. Alliance Capital on Monday said it had dismissed its president and chief operating officer, John Carifa, and mutual fund distribution chief, Michael Laughlin, because they were responsible for the firm's mutual fund unit when it allowed market timing. Furthermore, Alliance Capital has admitted it has "identified a number of market-timing relationships" and shared information about them with the Securities and Exchange Commission and the New York Attorney General’s office. The SEC and Attorney General are expected to file civil charges against Alliance Capital for market-timing within the next few weeks, and the firm has said it more than likely will have to pay fines and make restitution to its shareholders and funds. Little doubt remains that, at the very least, Alliance Capital suffered a serious compliance lapse and breached its fiduciary duty.

Alliance was on thin ice even before the alleged trading abuses. One of the final strikes against it was a recent prospectus filing that showed the expense ratios for virtually all of AllianceBernstein's international and domestic growth funds had increased substantially in the last year. That led us to add to our Fund Analyst Pans list four more AllianceBernstein funds that showed some of the biggest increases--including  AllianceBernstein Technology (ALTFX) (whose manager had previously been suspended from the firm for enabling market-timing arrangements) and  AllianceBernstein New Europe . Expense ratios on both funds' A share classes increased about 20%, to 2.24% and 2.54%, respectively, between 2002 and 2003. AllianceBernstein now has the dubious honor of having eight funds, more than any other family, on our  Analyst Pans list, and no funds on our  Analyst Picks list. By themselves, serious ethical lapses and rising expenses each offer ample justification to question a fund company's commitment to fund shareholders. Combined, they are practically an invitation to leave.

Damage Control
To its credit, Alliance has shown a desire to confront the scandal and limit the damage. It has suspended two employees and sent two executives packing, cleaning out, if not all the wrongdoers, at least some key players responsible for the behavior. A panel of independent directors is reviewing not only the firm’s trading practices, but also its compliance system and governance structure. Alliance’s current chief executive, Lewis Sanders, and the people he promoted to fill Carifa and Laughlin's posts, also are all from the investment research and management outfit Sanford C. Bernstein, which became part of Alliance in a 2000 merger and has a strong reputation in the institutional marketplace.

It's also encouraging that Alliance took steps, even before the scandal arose, to help eliminate conflicts of interest for managers running both retail mutual funds and more lucrative hedge funds. The firm stopped offering special incentives for hedge fund performance and instead now bases an investment team's compensation on the performance of all of the accounts it runs. Ostensibly, this system should prevent managers from favoring accounts that offer the potential for the highest fees and bonuses and ensure a more equitable distribution of investment ideas.

Promises to Keep
Still, these efforts remain works in progress, and we think investors have good reason to avoid the firm's funds. Its not certain the family would have launched its own market-timing investigation if New York Attorney General Eliot Spitzer had not lit a brush fire under the mutual fund industry in September by announcing the settlement with hedge fund Canary Capital Management. And even if Alliance Capital prevails in thwarting future market-timing arrangements in its funds, we still have grave concerns about a corporate culture that would allow a mutual fund manager to put the interests of well-heeled hedge-fund managers ahead of his own shareholders in the first place. You don’t change a corporate culture overnight.

The firm also could do more to better align its managers interests with those of its shareholders. For example, Alliance doesn't require its investment professionals to invest in the funds they manage. Thus, many at Alliance are insulated from the concerns of the average AllianceBernstein fund investor.

There is a lot that needs to change at Alliance Capital (besides its policy toward market-timers) before we'll recommend the firm's funds. As we have said before, we have never been cheerleaders for this fund family. Its fund expenses are high, and the long-term, risk-adjusted returns of many of its offerings are low. In fact, if you screened out from the AllianceBernstein lineup all the funds that failed to meet four simple criteria often used to describe good funds--above-average manager tenure, below-average expense ratio, reasonable volatility, and above-average returns among similarly styled funds--you’d be left with three single-state municipal-bond offerings out of more than 60 stock and bond funds.

Expenses Matter
As noted earlier, our central criticism of the firm relates to its costs. Within its lineup of domestic-stock funds, AllianceBernstein has one of the highest asset-weighted expense ratios among the top 25 fund families. True, the firm has lower front-end loads than many broker-sold fund families, but because of its high expense ratios, the complex's total costs are still very high. For example, an asset-weighted average of the 10-year total-cost projections (including sales charges and expense ratios) of the family's domestic-stock funds is higher than that of 23 of the top 25 mutual fund families. The asset-weighted average of the 10-year cost projections of the family's fixed-income and international stock funds also are higher than those of their typical counterparts at most of the top 25 firms. Further, 43% of Alliance funds charge more than 1.75%--a cost that makes it nearly impossible to overcome a benchmark.

Particularly vexing is the fact that Alliance Capital appears to have a two-tiered pricing plan for its investment services: It charges retail fund investors higher management fees than it does institutional clients for similar accounts. For example, Alliance subadvises the $6.8 billion in assets  Vanguard U.S. Growth Fund (VWUSX) for a management fee of 0.42%. Meanwhile, that fund's managers, Alan Levi and John Blundin, also run two in-house funds--the $2.2 billion in assets  AllianceBernstein Growth (AGRFX) and $757 million in assets  AllianceBernstein Mid-Cap Growth (CHCLX)--yet those funds charge management fees of 0.75%. As an industry leader, Vanguard wields considerable bargaining power when it comes to negotiating management fees with subadvisors. Still, it's befuddling why Alliance would charge its own shareholders 33 basis points more for similar services.

The onus is thus on AllianceBernstein to prove it is willing to act in a more shareholder-friendly manner. It has taken some promising steps, but the road is long. Until this family succeeds in shaking the muck of this scandal off its shoes, shareholders, after careful consideration of their individual goals, options, and tax situations, should think about selling and taking their money to a more reputable firm.

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