Allegations against Strong raise questions of trust for investors
By KATHLEEN GALLAGHER [email protected], Journal Sentinel
Sunday, September 14, 2003
Strong Capital Management Inc. was not the object of New York Attorney General Eliot Spitzer’s most damaging allegations of improper trading involving mutual fund companies and a hedge fund, Canary Capital Partners LLC.
And, it’s unclear exactly how Canary Capital Partners LLC was capitalizing on the opportunities Strong provided it.
But some in the industry say that shouldn’t stop shareholders from searching for a new fund company.
“The bottom line is you have a fiduciary responsibility to people, and if you don’t fulfill it, you don’t deserve their trust,” said Kunal Kapoor, associate director of fund analysis for Morningstar Inc. in Chicago.
Spitzer’s complaint against Canary does not implicate Strong, as it does Bank of America, in the most serious charge of allowing Canary to engage in late trading. Late trading, which is illegal, helped Canary use after-market information by letting the hedge fund get the closing price for fund share trades made after the market closed.
However, Spitzer’s complaint implicates Strong in allowing Canary to market-time by trading five Strong funds more actively than other shareholders, and in providing to Canary lists of those funds’ holdings more often than other shareholders received them.
In exchange, Strong got commitments from Canary to keep as much as $18 million in a Strong brokerage account to trade the funds, and to keep another, unspecified amount of “substantial additional assets” in Strong hedge funds, the complaint says.
Those actions, if proved true, are at the very least unethical.
“Active trading of a mutual fund hurts the buy and hold investors — that’s unambiguous,” said Jay R. Ritter, a finance professor at the University of Florida in Gainesville.
“What’s missing here is, what motivation did Canary have to be actively trading these Strong funds?”
Strong has repeatedly declined to comment about Spitzer’s allegations, saying only that the firm is cooperating with Spitzer’s office and is conducting an internal review.
The most lucrative types of funds to market-time are those containing stocks that are inefficiently priced. Spitzer’s complaint says the best chances to find inefficient, or “stale,” prices are in securities such as high-yield bonds, and small company and foreign stocks.
The five funds Strong is accused of having allowed Canary to market-time in — the Strong Growth 20, Growth, Advisor Mid Cap Growth, Large Cap Growth and Dividend Income funds — didn’t contain those types of securities.
“If Strong was permitting in and out trading of an international fund — there what was going on would be clear to me,” Ritter said. “Trading in and out of a big cap growth fund — that’s kind of a mystery where something else had to be going on.”
Strong gave Canary a complete lists of the stocks in four of its growth funds at least four times between November 2002 and June, according to the complaint. Strong gave Canary the Dec. 31 lists of holdings the quickest — five trading days after Dec. 31, the complaint says.
During the same period Strong was providing the lists to Canary, shareholders got them only once. Strong listed the Dec. 31 holdings for three of the funds in its semiannual shareholders report, which it made public more than 40 trading days later, according to Securities and Exchange Commission records.
“Hedge funds have been getting these portfolios earlier, and that’s unfair,” Kapoor said. “It just goes back to the notion different kinds of investors are being treated differently — and the whole premise of a mutual fund is that everyone should be treated the same.”
Because mutual funds are priced just once a day, Spitzer’s market- timing allegation doesn’t mean Canary was able to move in and out of the funds during the trading day. But it does suggest Canary was able to trade in each fund as many as five times a week without being rejected by Strong’s transfer agent for “flipping.”
What could Canary have done with the market-timing opportunities and portfolio holdings Strong provided?
Canary could have taken slight advantage of stale pricing in some of the five funds’ stocks. If Canary knew what the underlying companies were actually worth, it conceivably could have bought the fund on certain days at a slight discount.
“I’ve got to think something else is going on, but what it is, I can’t figure out from the complaint,” Ritter said.
Canary might have had another slight advantage from knowing what the funds held.
For example, say Canary bought shares of the Strong Growth 20 Fund. The next day, if the fund’s stocks were up, Canary could create a hedge that would lock in that rise by shorting, or borrowing and selling, those stocks.
Then if the market dropped before the close, Canary would have still gotten the bump in value the fund’s shareholders missed since the fund isn’t priced until the close.
Such a hedge would not have been without risk, but it clearly would have given Canary an edge other holders didn’t have.
“We think what a fund should be doing is discouraging market timing, not helping them hedge better,” said Eric Zitzewitz, an assistant professor of economics at the Stanford Graduate School of Business whose research paper about arbitrage-proofing mutual funds was cited by Spitzer.
If Canary did create such a hedge, it would marginally hurt the fund’s shareholders because Canary’s stock sales would put more downward pressure on the stocks in the fund.
When Canary bought and sold the Strong fund shares, it also would create more transaction costs that long-term shareholders would have to bear the brunt of.
Still, the information in Spitzer’s complaint doesn’t point to Canary generating huge profits from the Strong funds. Some say Spitzer may have more information that isn’t in the complaint.
“That’s almost certain, at least in my opinion,” Ritter said.
Lacking such additional information, though, should shareholders stick with Bank One, Janus and Strong — the fund companies that were only accused of market timing?
“That’s a hard argument to make right now,” Kapoor said.
“This is people’s hard-earned money. When you invest it, you should expect a certain level of confidence and fair play — and I don’t think these investors got it.”
