NEWS ANALYSIS
Funds’ fears and fees led to timing scandal
By GRETCHEN MORGENSON New York Times
Monday, November 10, 2003
In the early 1990s, mutual fund companies occasionally allowed select institutional clients to trade fund shares rapidly, a practice known as market timing. But such trades were relatively small and usually limited to funds that held corporate bonds or mortgage-backed securities, hedge fund executives and others said.
“I worked on Wall Street in the early- to mid-’90s, and this practice was taking place then,” said Frank Partnoy, professor of law at the University of San Diego and the author of “Infectious Greed: How Deceit and Risk Corrupted the Financial Markets.”
That changed after the stock market collapsed in 2000 and the easy money in initial stock offerings disappeared. Market timing in mutual funds — the in-and-out trading of fund shares that is now the subject of intense regulatory scrutiny — became a common investment strategy.
Hedge fund managers aggressively sought to identify discrepancies in fund share prices and to capitalize on them by rapidly trading those shares.
To understand why mutual fund companies would grant special trading privileges to hedge fund investors, privileges that cost their long-term shareholders untold millions in losses, you have to recall the climate in the securities market in 2000, hedge fund executives say. With stocks in free fall, mutual fund managers found it tough to generate good performance. And as their assets under management plummeted, so did their fees.
Fund managers, interested in keeping their fees up, were under pressure to attract fresh money or keep existing assets from disappearing. Allowing big investors to conduct market timing trades seemed to be one solution because, in exchange for the privilege of conducting such trades, hedge funds would agree to invest additional money in the mutual fund.
Even though mutual fund companies had policies against the frequent trading of fund shares, hedge fund managers of all stripes were soon striking deals to trade fund shares and attracting investors with promises of relatively easy gains.
Mutual funds’ embrace of market timers is now showing up in documents released by securities regulators investigating improper practices at funds. For example, the complaint against Putnam Investment Management, filed by Massachusetts regulators on Oct. 28, stated that the fund giant allowed one of its retirement plan clients, Boilermakers Local Lodge No. 5, to trade in and out of fund shares frequently because Putnam sought to expand its retirement plan business and keep the plans it already had happy. Such trading was forbidden for all customers, according to Putnam’s stated policy.
The complaint states that Putnam executives allowed Local Lodge No. 5 to trade frequently because lodge officials had helped Putnam win a large account from an associated organization, Boilermakers International.
Putnam’s eagerness to accommodate the Boilermakers is reflected in an e-mail message dated Jan. 3 in the complaint from a Putnam employee, Robert Gowdy, that said, “Boilermakers No. 5 is a long- standing profitable client which was very instrumental in our winning” $100 million in business from Boilermakers International.
Putnam said it regretted that timing had occurred in its funds. But it said it had not committed fraud.
Market timing is a misnomer, of course. What these traders were doing was trying to capitalize on pricing anomalies or discrepancies in securities the fund held. This is also known as securities arbitrage.
The easiest way to profit in this manner is by trading in international mutual funds. These portfolios hold stocks that do not trade when U.S. markets are open but that may respond to the direction American markets take when the shares open for trading the next day. Furthermore, shares of foreign companies may not trade as frequently as big domestic stocks and therefore may be more likely to have stale prices than those of more liquid securities.
In the early 1990s, market timers found their best opportunities in fixed-income funds, hedge fund experts said. Securities in junk bond funds, for example, do not trade as frequently as big-name stocks do; some do not even trade each day.
Getting accurate prices on 300 illiquid securities is time- consuming and difficult for fund managers to do, so some bond prices in a portfolio were allowed to go stale. When interest rates moved significantly, this created great profit potential for investors who knew that the fund’s pricing of a certain bond had not been updated to reflect the rate move.
