Nov. 4–Bad news just keeps oozing out of the mutual fund industry, and increasingly it appears that the claim of federal and state regulators is true — that much of the fund industry is riggedagainst small investors.
The once pristine image of mutual funds continues to be damaged by almost daily revelations of shady trading practices and firing of executives.
On Monday, the chief executive officer of Putnam Investments, one of the nation’s oldest and most respected fund companies, was ousted amid fraud accusations. Lawrence Lasser, 60, will leave the Boston-based fund company immediately, six days after Putnam and two former money managers were accused of improper short-term fund trading.
“It appears that the abuses at fund companies was a lot more widespread than anyone imagined,” said Laura Lutton, a mutual fund analyst at Morningstar. “It is especially disturbing that fund managers at one of the nation’s oldest fund companies appear not to have been acting in the best interests of its shareholders.”
The Putnam news was bad, but perhaps even more jarring were findings that the Securities and Exchange Commission presented to Congress on Monday. SEC enforcement director Stephen Cutler said the SEC found e-mails showing about 10 percent of fund groups may have been involved in “late trading” — a technique for taking advantage of earlier closing times in overseas markets.
Additionally, the SEC found that about 30 percent of the fund firms had disclosed their portfolio holdings to selected clients more often than normal.
“To find out that fund managers may have been stealing from the very individuals they were hired to protect is very disturbing,” Ms. Lutton said. “And I think we still have a long way to go before we get all the abuses on the table.”
It’s difficult to gauge the ultimate impact these revelations will have on the $7 trillion mutual fund industry. So far inflows into mutual funds have been strong throughout the year, including $25 billion in net inflows in September, when many of the allegations were first aired.
However, investors “have been betrayed,” and no one knows the long-term impact, said Hal Degenhardt, administrator of the Fort Worth regional office of the SEC. Mutual fund managers have “the very highest responsibility” to protect their shareholders’ interest — a fiduciary responsibility — and that has been breached, he said.
“I can say the commission is diligently looking at all fund companies that may have problems,” Mr. Degenhardt said. “It is time for action. If regulators take quick action, that may minimize the impact.”
Avi Nachmany, director of research at Strategic Insight, a mutual fund research company, said that while the entire industry has been tainted, in truth very few fund companies are involved.
“This is another case where the sins of a few are making the entire industry look guilty,” Mr. Nachmany said. “If you look at the positive fund flows, clearly most investors still have the conviction that while mutual funds may be imperfect, they are still the best place to invest.”
At least in the short run, any negative impact will probably be most felt by the fund companies that are targets of the investigators. Morningstar, which rates mutual funds, has advised investors to consider selling their shares in several of the fund companies implicated in improper trading practices.
They are: Bank of America Corp., Janus, Banc One and Strong Capital Management Inc. New York Attorney General Eliot Spitzer began cracking down on mutual fund companies in September for widespread allegations of improper fund trading.
Since then, Bank of America has fired two executives for late trading, but several other fund companies also are being investigated. Richard Strong recently stepped down as chairman of Strong’s mutual fund group. More than 30 people have been suspended or fired since Mr. Spitzer began the probe.
With late trading, a mutual fund client — typically a hedge fund — is allowed to buy or sell fund shares after the normal close of trading at 3 p.m. Dallas time and still receive that day’s closing price. Companies release a lot of news after the closing bell, so a hedge fund can profit by getting the 3 p.m. price even though it didn’t really buy the fund until, say, 9 p.m. Most investors who buy after 3 p.m. get the next day’s closing fund price.
Ms. Lutton said Morningstar considered recommending that investors sell shares of Putnam, but stopped short of that action after Mr. Lasser stepped down.
“Our official line on Putnam is for investors not to send them more money until this is all corrected,” Ms. Lutton said.
Since the allegations against Putnam first emerged on Oct. 28, pension clients including state funds in Massachusetts and Iowa have withdrawn more than $4 billion from Putnam. Shares of Putnam’s parent company, Marsh & McLennan Inc., have lost 14 percent.
A spokeswoman for Marsh & McLennan refused to comment about the matter except to say that Mr. Lasser “has left the company.”
Mr. Spitzer often uses the term “market timing” to refer to what Putnam and some of the other funds were doing. The most lucrative market timing trades are in mutual funds that focus in international markets, because European markets close hours before the U.S. markets.
With this strategy, a mutual fund allows a client to buy shares in an international fund before the 3 p.m. close and then typically sell it the next day. This can be profitable because an overseas company may release a positive earnings surprise after the European markets close but while the U.S. markets are still open.
In other words, the client buys shares in the international fund on one day and is all but assured of selling it higher the next day.
This is not illegal, but it forces the mutual fund to keep more cash on hand for redemptions than it otherwise would. This is cash that would otherwise have been put to work in the market. And in Putnam’s case, some of its own fund managers were market timing.
“You would think fund managers would be looking out for their shareholders, not themselves,” said Ms. Lutton of Morningstar.
–Bloomberg News contributed to this report.
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