Nov. 17–Mutual fund market-timing and late-trading scandals won’t wipe out individual investors like the accounting frauds at Enron and WorldCom did.
But in a two-year parade of Wall Street misdeeds, the mutual fund industry has betrayed an alarmingly large number of people in small bites, experts say.
“We still don’t know how many more companies could be implicated,” said Larry Barton, president of the American College, which educates financial advisers. “This has created one of the first (scandals) that touches tens of millions of investors.”
Mutual funds, which represent a basket of stocks, were meant to be among the most secure investments possible, with professional management, diversification and a focus on long-term returns. The bull stock market of the 1980s and 1990s lured more than half of U.S. households to invest in mutual funds, which now hold $7 trillion in assets.
The betrayals of mutual fund integrity are drawing media attention and have implicated two Denver-based mutual fund giants. Some investors are worried, yet they have little clue what’s gone wrong.
Here’s what you need to know:
— Mutual funds, unlike stocks, set a price once each trading day, at 4 p.m. Eastern time.
— Place an order before 4 p.m. and get that day’s price. Place an order after and get the next day’s price.
— Some traders, either through a brokerage or a retirement plan, place orders after 4 p.m. and get that day’s price. That’s called late trading and is illegal.
New York Attorney General Eliot Spitzer, a modern-day Eliot Ness fighting financial corruption, likens late trading to betting on a horse race after it is run.
Late trading can be hard for mutual funds to monitor and stop because it is hidden through brokerage accounts and retirement plans. A secondary issue is when mutual fund officials allow late trading in order to gain fees or some other benefit.
Stanford University economics professor Eric Zitzewitz estimates that late trading cost investors $400 million annually before regulators cracked down this year.
Late trading is fairly easy to fix, however: demand that all orders be completed by 4 p.m. to get that day’s price. That remedy is under consideration by the U.S. Securities and Exchange Commission.
A more widespread practice, which is not strictly illegal, is called market timing, or the short- term trading of mutual fund shares. In some sense, it’s the mutual fund equivalent of day trading in stocks to turn a quick buck.
Denver-based Janus Funds, which manages $150 billion, has admitted to allowing 12 market-timing agreements and has promised restitution to affected mutual fund holders.
Invesco Funds Group, also based in Denver, is under investigation by Spitzer’s office for potential market-timing abuses. Invesco manages $19 billion in assets.
Mutual funds typically discourage market timing because it adds costs and dilutes overall return on investment, said Ron Meier, a professor at the College for Financial Planning in Greenwood Village.
Like bookies seeking inside information on sports teams, market- timers use a variety of criteria to gain an advantage. One rule of thumb is “sell in May and go away,” meaning that, historically, stocks have tended to underperform from May to September.
That didn’t happen this year, however, which indicates that market-timers can be wrong as often as they are right.
“Most of the folks that do that type of activity can’t show the results,” said Ray Trotta, author of the book, “Translating Strategies into Shareholder Value.” What has changed in recent years is that some market-timers found a method so rich in its payoff that they were willing to push mutual fund groups to violate policies intended to protect the average investor.
Their method relies on something called “stale pricing.” Remember that mutual funds are priced once a day. Stale pricing happens when securities in mutual funds have not traded for several hours and don’t reflect current value based on financial news in the U.S. or around the world.
Asian markets, for example, close after midnight Eastern time, but a U.S.-based mutual fund holding Asian stock would price at 4 p.m. New York time.
Assume the U.S. stock market goes up 5 percent on a Tuesday and Asian markets follow, which is often the case. On Tuesday in New York, a market-timer can buy a mutual fund that holds Asian stocks and sell on Wednesday, enjoying a similar 5 percent gain. Here’s how: The mutual fund market-timer is buying Asian stocks at a price that is almost guaranteed to rise in value by Wednesday.
If that timer put $5 million into a $100 million fund that held such Asian stocks, she would gain almost $250,000 that might have otherwise gone to the other investors in the mutual fund.
Such market timing is estimated to cost investors in foreign-stock mutual funds about $5 billion a year.
Even if timers don’t profit immediately, they can cause other problems, Meier said.
When a market-timer moves big money into a mutual fund, it forces the portfolio manager to eventually start buying stocks or bonds as investments. If the same big money moves out again within a few days or weeks, it can force the manager to sell stocks and bonds to raise cash to cover the payout.
“Portfolio managers may have to sell stocks they don’t want to sell,” Meier said.
The combined $5.4 billion loss to investors through late trading and market timing is a fraction of the $7 trillion in assets managed by the mutual fund industry.
But it represent a huge violation of trust, analysts said.
To address market timing, leading figures in the mutual fund industry have asked that regulators impose a mandatory 2 percent charge on fund shares that are sold within five days of purchase.
This would discourage some market-timers and cover some of a fund’s transaction costs when the timers persist in rapidly buying and selling fund shares.
Another fix is to have mutual funds predict what a “fair” price is for their funds and adjust it. Effectively, funds would price a day ahead to account for profits that the timers are seeking, an approach Zitzewitz said he favors.
Beyond performance, risk and investment strategy, investors need to weigh a fund’s trustworthiness, Barton said.
A common reaction when investors are betrayed is to pull their money out of the mutual fund. The mutual fund scandals have triggered such withdrawals. Barton advises that investors should stay calm and let the investigations and reforms play out.
“People should not be moving their money out of anger,” he said.
Rash moves by the average investor could prove more costly than the harmful trading practices, he suggested. In addition, investors may leave one fund only to find its replacement also tainted, he said.
HEADS ARE ROLLING
The market-timing and late-trading scandals have resulted in the suspension or firing of more than 40 people in the mutual fund industry. Among the higher-profile casualties:
— Gary Pilgrim and Harold Baxter, co-founders of the Pilgrim Baxter fund family, were forced to step down because of frequent trades that Gary Pilgrim made in his own fund group. Baxter was allegedly aware of the trades but didn’t prevent them.
— Richard Strong resigned Nov. 1 as chairman of Strong Mutual Funds after the discovery of short-term trades he made in his own funds. Strong also could face a criminal probe for his activities.
— Putnam Investments CEO Lawrence Lasser resigned Nov. 3 after 18 years. Putnam also fired four fund managers — Justin Scott, Omid Kamshad, Carmel Peter and Geirluv Lode — for rapid trading in the funds they managed.
— Alliance Capital Management fired president John Carifa and Michael Laughlin, chairman of the mutual fund distribution unit, on Tuesday for allowing market timing under their watch. The group also suspended two executives — Gerald Malone and Charles Schaffran — for allowing market-timing transactions.
— Fred Alger Management Inc. suspended workers after an internal probe. One, James Connelly Jr., pleaded to felony charges of obstructing the probe. Connelly also faces civil charges that he allowed market timing in some Alger mutual funds.
— Bank of America has fired staffers related to allegations that market timing and late trading by Canary Capital Partners was allowed in some of its funds. Broker Theodor Sihpol III was fired and is charged with grand larceny and a violation of business law. Charles Bryceland, former head of the bank’s brokerage and private-banking office, and Robert Gordon, former head of the bank’s mutual- fund business, were fired. Neither are charged with wrongdoing.
— Bank One allowed Canary to market time 11 of its mutual funds, allegedly in exchange for Canary’s taking out a large loan and weighing a large investment in a Bank One hedge fund. In October, the bank replaced One Group president Mark Beeson and John AbuNassar, former head of Bank One’s institutional asset management unit. Neither is charged with a crime.
— Denver Post wire reports contributed to this summary.
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