Mutual Funds
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You deserve better from mutual funds
For decades, they've treated investors as second-class citizens rather than as its bosses. The industry's apathy even in the midst of scandal is breathtaking.
By Timothy Middleton
The continuing revelations in the mutual fund scandal expose a moral vacuum in the money-management business that, under the lash of publicity, is finally drawing the rights of fund shareholders into the public spotlight.
In this industry you never hear the word investor used, says Don Phillips, managing director of Morningstar, which tracks mutual funds. They call us 'customers.' Investor would imply we are the ones they are working for. Thats the spirit of the '40 act -- the investor is the top of the food chain. They see the investor at the bottom of the food chain.
The securities act of 1940 that created the modern fund industry makes shareholders, and shareholders alone, owners of mutual funds. Directors are required to represent their interests, and only their interests. In reality, as this scandal shows, fund directors are often mushrooms in the basements of mammoth financial-services superstores, paid to slumber in the dark while their bosses shoplift our assets.
The industrys reaction to the spreading scandal has been a scandal itself. Matt Fink, president of the Investment Company Institute, says that trade groups policy on the revelations is threefold: Anybody who violates the law ought to be punished, he says. Secondly, if any shareholders have been hurt, they have to be made whole. And if there are any gaps in regulations, they ought to be closed.
That policy is breathtakingly disingenuous. The most widespread violation of shareholder rights, letting arbitrageurs clip investors profits by market-timing, isnt illegal, meaning it may be tough to bring charges. Secondly, it isnt societys job to make shareholders whole -- its the industrys job to protect them from having to be made whole. And the gaps in regulation are the industrys own indifference to the worst practices of its members.
Lots of funds do everything they can to stop market-timers from going in and out, Fink insists. But it can be very hard to ferret out.
The fund scandals fallout
Horse hockey. Both Alliance Capital and Prudential Securities managed to do it in less than 30 days, once the New York attorney general lit a fire under them.
Those two fund complexes announced last week that internal investigations had discovered instances of market timing involving their funds. Alliance said it suspended a portfolio manager and a salesman whose customers are hedge funds. Prudential Securities, which is majority-owned by Wachovia (WB, news, msgs), said a number of its brokers had resigned, including the managers of offices in Boston and Garden City, N.Y.
The announcements by those companies followed the Sept. 3 revelation by New York Attorney General Eliot Spitzer that he was investigating fund industry trading practices. At the time, Spitzer, who previously forced Wall Street firms to change how they treat individual investors, named four fund complexes he said had engaged in improper dealings with hedge fund Canary Partners. The fund companies weren't charged. Canary Partners and its manager, Edward Stern, agreed to pay $40 million to settle charges involving late trading with mutual funds.
On Thursday, a former trader with hedge fund Millennium Partners pleaded guilty to making trades with hedge funds after the market closed. The same day, Citigroup's (C, news, msgs) Smith Barney unit disclosed that it had fired a broker for engaging in a form of late trading of fund shares.
Late trading is illegal. It involves a fund allowing someone to buy shares after the close at the 4 p.m. price, even when after-market news promises to move the price the next trading day. Spitzer has called it akin to betting on a horse race after it's over.
But apparently the more common practice is market-timing, which the 1940 securities act doesnt specifically forbid. With market timing, traders take advantage of "stale" fund prices. For instance, for funds that trade in foreign securities, there can be a lag before market moves overseas are calculated into a fund's net asset value. So the hedge fund could jump in at a lower price and quickly sell at a higher price.
Most fund complexes forbid market-timing in their prospectuses, and most have internal controls intended to identify and eliminate it. Fink of the ICI refers to them as the market-timing police. Car 54, where are you?
Market-timing hurts
Timing hurts long-term shareholders several ways. First, the profits it harvests have been earned by shareholders, who lose a fraction of them when timers buy into a fund only to sell the next day. Second, it increases a funds trading costs, a hidden expense not revealed in the published expense ratio. Third, it can require fund managers to hold cash reserves to meet redemptions, which in turn can cut returns because that money isn't invested.
For all these reasons, many fund complexes have imposed redemption fees of 2% to 3% on investors who own shares less than six months. That range is the estimate of what fund companies believe market timing costs other investors. But this was waived for at least some of the hedge funds involved in market timing.
The fund industry contends that timing is difficult to detect because many fund flows arrive in so-called omnibus accounts that fund companies have with brokerage firms and other financial intermediaries. For example, when you buy a fund in your 401(k) plan, the firm that administers the plan -- and also, probably, myriad others -- aggregates trades and reports the sum of all of them to the fund company.
They send funds netted numbers, Fink argues. The fund doesnt know what Joe Blow or Tim Middleton or Matt Fink did that day.
Nonsense. As Spitzer has alleged, and Alliance and Prudential have confirmed, the illicit business was solicited or accepted from hedge funds through fund companies own sales forces in exchange for sticky assets in other funds, on which they could earn fees.
The issue dates back at least to 1997, when Fidelity Investments discovered timers using some of its funds and threw them out. Fund gadfly Mercer Bullard, a former Securities and Exchange Commission lawyer, publicized the hedge-fund link in 2000 in articles published by TheStreet.com.
Less than nothing
Since then, federal regulators have done nothing, at least nothing that has become public, to end the practice. The industry has done less than nothing, aggressively fighting virtually every effort to bring more transparency to fund operations, from disclosing managers holdings of their own funds to disclosing how they vote proxies on the shares they own.
Phillips at Morningstar says he has been inundated by messages from investors and financial advisers who are hopping mad because of the industrys laxity. So have I -- scores of them.
One e-mail I received as I was writing these words, which noted that I recommend investors limit their dealings to ethical operators, says this: Why don't you tell us which ones are ethical operators? Could it be that you don't know? A person shopping for an ethical fund family may have come across Nations or Bank One and wouldn't know there was a problem until it is exposed. So tell us in advance.
The message was signed Larry, and I told him what Im telling you: Youre right. I dont know. Im encouraged, however, that Alliance and Prudential have owned up to the issue. I think other firms will. I think shareholders, not to mention a state attorney general or two, will make them own up to it. Massachusetts authorities may have prompted Prudentials action at its Boston office.
And someday, when it realizes its credibility has been shredded in this scandal, maybe the Investment Company Institute will take some action besides the reflexive twitching of an annoyed, and annoying, dinosaur.
At the time of publication, Timothy Middleton didnt own any of the securities mentioned in this article.
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