MARKETS
Average investors have little defense against dishonesty on Wall Street
By KATHLEEN GALLAGHER [email protected], Journal Sentinel
Sunday, September 7, 2003
One of the most frustrating things about the allegations by New York Attorney General Eliot Spitzer against the mutual fund industry is that the average investor, no matter how diligent, had no way of knowing that questionable trading was taking place.
Spitzer’s spotlight on mutual funds, like the earlier one he put on research analysts, shows just how much Joe Investor has to trust Wall Street — and how much Wall Street allegedly has taken advantage of that trust.
For shareholders in those companies’ funds, Spitzer’s allegations at least raise issues of trust betrayed.
“You trust them to act as a fiduciary for you — to take your money and invest it, at least according to the principles and bylaws they lay out in their prospectuses — and these four firms, they haven’t done that,” said Paul Herbert, a mutual fund analyst at Morningstar Inc. in Chicago.
Spitzer’s complaint last week targeted a New Jersey hedge fund and four mutual fund companies, including Menomonee Falls-based Strong Capital Management Inc., and alleged two practices: late trading and market timing.
Late trading involves buying mutual fund shares at the closing price after the market shuts down.
It is illegal because it allows people to use after-market information while paying the closing price.
Or, as Spitzer’s complaint put it, it’s like “betting today on yesterday’s horse races.”
Market timing involves short-term, “in-and-out” trading of mutual fund shares, which has a detrimental effect on the longer-term shareholders for whom mutual funds are designed. It isn’t illegal but is frowned upon in the industry and many fund prospectuses promise they will actively work to make sure it doesn’t happen.
Spitzer’s complaint accused Bank of America of allowing market timing and late trading. It accused Bank One, Janus and Strong of allowing market timing.
A research paper written by Eric Zitzewitz, a Stanford business professor, estimates long-term shareholders lose a total of $5 billion a year because of speculators who trade in and out of mutual funds.
Favoring some investors
Many say the larger concern for investors is that their fund companies would “rip them off” by putting the interests of more powerful shareholders first.
Few industry professionals are willing to talk about the situation because Spitzer’s office and the U.S. Securities and Exchange Commission are casting a wide net.
Spitzer is firing subpoenas at many of the biggest players in the fund industry, and the SEC is asking fund companies to provide detailed information about any involvement in late trading and market timing activities.
For some, such as William H. Bergner, Spitzer’s attack on the mutual fund industry is the last straw.
Bergner, the Phoenix-based partner and chief investment strategist for Brookfield Investment Partners LLC in Brookfield, fired off a letter to William H. Donaldson, chairman of the SEC, soon after Spitzer’s revelations.
“The last few years have been a nightmare of ugly exposures not merely of dishonest individuals who will exist in any endeavor, but also of gross violations of existing laws, structural self-dealing by many of our largest and well-known financial institutions and gaping holes in enforcement by the Commission and other agencies,” Bergner wrote.
Bergner’s letter suggests that Donaldson, the SEC’s new chairman, has a good opportunity to bring “openness, integrity and strict enforcement” to this country’s securities markets.
“While the process is ugly, getting sunlight on the truth of the situation is what’s important,” Bergner said in an interview.
Of the eight industry professionals whom a reporter called to discuss Spitzer’s latest crusade, only Bergner and Herbert, from Morningstar, were willing to attach their names to any discussion of the allegations.
Those who were unwilling to talk publicly, several of whom managed or had managed mutual funds, painted an ugly picture of the pressure they got (or the unsolicited attention their fund got) from speculators who wanted to trade in and out of their funds for quick profits.
One manager shut down a fund because of the harm that market timers were inflicting. Another told of the sleuthing necessary to ferret out a group of stock brokers who had pooled- client money to trade in and out of his fund.
The pressure, they said, came not only from the market timers but from their own sales forces, who viewed the opportunities as lucrative.
How can average investors try to prevent their mutual fund companies from abusing them?
“Look at things like expenses and the number of independent directors,” Herbert said. The higher the fund’s expenses relative to similar funds and the fewer directors the fund has, the more chance there is the fund won’t be operating in the best interest of all shareholders, he said.
Bergner agreed, citing The Vanguard Group as one of the fund companies that has consistently kept its fees low and tried to be open with shareholders.
“In the short term, you have to go with the simplest model — certainly their fees are low, and there’s no reason to pay more,” Bergner said.
The Vanguard Group was among several companies that said Friday they’d received subpoenas from Spitzer’s office as part of the investigation.
Bergner says his hope is that regulators will force the entire investment industry to disclose the fees customers are paying in very simple terms and provide more openness to shareholders.
“Because of the amount of money involved and the amount of influential people involved, it’s going to take a long time,” Bergner said. “But I think we’ll get there.”
