NEW YORK (AP) – The mutual funds scandal has taken on a new, potentially much more damaging dimension with accusations that fund managers and top executives engaged in their own improper trading atthe expense of other customers.
The allegation that even someone as highly placed as Richard Strong, founder of the Strong mutual fund family, was involved has infuriated investors and is a serious black mark against the $7 trillion industry, which long has enjoyed a squeaky-clean reputation.
At issue is not the money actually lost by investors, which at most may amount to a couple of billion dollars spread among some 90 million U.S. mutual fund shareholders. The real price is in a loss of trust that already is scaring some investors away.
“This is the biggest stink that’s ever happened to the mutual fund industry,” said Roy Smith, professor of finance at the Stern School at New York University. “You could say the first couple of cases of this were because of competition, but when the managers start to do it themselves, it’s nothing more than putting your thumb on the scale.”
Until this week, allegations in the spreading scandal focused on preferential treatment by fund managers of big-money customers, who were allowed to book after-hours trades at prices already closed to most fund shareholders and to engage in quick in-and-out investing known as market timing. Although market-timing is not illegal, most funds prohibit it because it racks up expenses that hurt long-term shareholders.
Now, the charges include trading by executives and fund managers themselves. Their profits came at the expense of fund shareholders whose interests they are supposed to protect.
Since the scandal broke this summer, the fund industry had argued that improper trading was the work of a few overzealous individuals eager to expand business, rather than a systematic problem. Two of the three charges brought in the investigation before this past week had been against brokers; the third charge involved an executive accused of covering up the trading.
But filings Tuesday by the Securities and Exchange Commission and state of Massachusetts suggested the trouble may be more widespread.
Those documents allege that two international fund managers for Putnam Investments, Justin Scott and Omid Kamshad, reaped hundreds of thousands of dollars each with excessive short-term trades in Putnam funds they managed.
Putnam, which denies any wrongdoing, was aware of the activity and warned them to stop in early 2000. But Scott and Kamshad were allowed to keep their profits and continued to trade after the warnings, according to the filings. They were not fired until late last month.
“As a result of his short-term trading, Scott realized hundreds of thousands of dollars in gains,” the SEC complaint said. “Scott often traded millions of dollars worth of mutual fund shares.”
Richard Strong has not been indicted or otherwise charged in the fund scandal, but he acknowledged conducting short-term trading in some of his and his family’s personal accounts that were invested in Strong funds, despite the funds’ policy against such trades.
In a statement, Strong did not say how much money the transactions involved, but said he would personally compensate the funds for any financial losses, although he does not believe the transactions were harmful.
His offer came a day after New York Attorney General Eliot Spitzer indicated charges against Strong and his company were forthcoming. A source familiar with the probe has estimated Strong’s market-timing transactions yielded as much as $600,000 – pocket change to a man Forbes magazine estimates is worth $800 million.
Strong also said he would step down if it became appropriate – but that may not be enough to reassure shareholders angered that the man supposed to protect them failed to do so. Strong is chairman of Strong Financial Corp., which manages nearly $43 billion in assets.
“If you own a Strong fund, how can you not react to this? At end of the day, you might keep your money there, but still you’re going to think about it,” said Russ Kinnel, director of fund analysis at fund-tracker Morningstar.
Several states were pulling their pension funds from Putnam Investments, raising concerns about a possible run on its funds by worried customers.
To reassure investors, the fund industry’s trade association, the Investment Company Institute, is proposing tightening up on the 4 p.m. closing time for buy and sell orders for funds. It also wants the government to impose a 2 percent redemption fee on short-term transactions to discourage market-timing, and is asking fund firms to rewrite their ethics codes to prevent trading abuses by employees.
The SEC is expected to consider new rules for funds by the end of November.
That may not be enough to counter the effect of more bad news on already nervous investors.
Regulators have subpoenaed dozens of financial institutions, including Janus Capital Group, Fidelity Investments and Morgan Stanley, since this summer. Before the Putnam and Strong news, a former Fred Alger & Co. executive and a broker at hedge fund Millennium Partners had admitted fund-related wrongdoings. A former Bank of America broker pleaded innocent to similar charges.
“There’s no question that this is not a few bad apples but rather an industrywide problem,” said Mercer Bullard, founder of FundDemocracy.com, a shareholders’ advocacy group. “It wouldn’t surprise me if there were other types of fraud out there we don’t know about yet.”
