Scandal Finds the Funds' Sly Secrets


By Amey Stone On Sept. 3, New York Attorney General Eliot Spitzer announced he had found evidence that major fund companies were complicit in "widespread illegal trading schemes" that potentially cost shareholders billions of dollars. Janus, one of the those named, said in a statement issued the same day that it will continue to cooperate with the inquiry, adding: "Janus is reviewing the complaint closely and is committed to ensuring that the company continues to act in the best interest of Janus fund shareholders."

Spitzer's complaint against hedge fund Canary Capital Partners, which settled the case for $40 million while neither denying nor admitting guilt, outlines two primary strategies. The first, and more serious, is late trading, in which Canary was allegedly allowed to purchase funds at the closing price after 4 p.m. and thereby take advantage of events that occurred after the market closed. The second strategy described is market-timing. Spitzer alleges that Canary was allowed to trade in and out of funds to take advantage of short-term pricing inefficiencies at the expense of long-term shareholders.

"COMPLETE SHOCK." "The industry has been pounding the table about how clean it is," says Brian Portnoy, a senior fund analyst at fund-tracker Morningstar. "But clearly there are some unsavory practices taking place below the radar."

Mark Foster, chief investment officer at Kirr, Marbach Partners in Columbus, Ind., says: "This is a black eye for the industry that will probably lead to additional regulation." Foster, a shareholder in Janus Capital Group (JNS), which has been linked only to the market-timing activities, says he was particularly surprised at the late-trading allegations. Eric Zitzewitz, an assistant professor of economics at Stanford, takes it a step further, saying Spitzer's late-trading assertions "came as a complete shock. That is so egregious."

Indeed, it is a shocker if fund companies have been making cozy deals with hedge funds that allow them to trade after the 4 p.m. close. As for Spitzer's charges that firms have been allowing market-timing to go on unimpeded, the industry has had that one coming to it for a while.

Funds had little incentive to change

Fund companies have long known that arbitrageurs and market-timers were profiting from trading in and out of mutual funds at the expense of long-term shareholders. Academics like Zitzewitz have studied how they do it, and they have proven that the problem has grown much worse in the past year.

Shareholder advocates have urged the industry to take a harder line against such practices, and entrepreneurs have launched businesses to help fund companies price funds in a way that makes those complex trading strategies ineffective. (For a detailed look at how market-timing trading strategies hurt fund shareholders, see BW Online, 12/11/02, "When Market Timers Target Funds".)

READY TO BLOW? Yet it was clear even before Spitzer's charges that many fund companies, while saying they were doing their best to thwart traders, weren't doing so. And they may not have had much incentive. Shareholders -- who rarely understood just how the trading strategies were hurting them -- weren't clamoring for change. And investors aren't fans of redemption fees, the most common tactic to subvert market-timers. Plus, the legal requirements around pricing of funds were murky, allowing for some wiggle room.

Zitzewitz, whose research found that market-timing cost fund investors $4 billion in 2001, notes "a real lack of enthusiasm" on the part of fund companies to deal with the problem. He couldn't figure out why so many companies would allow such a practice to continue, since it eats into returns. Now, he believes the special deals alleged by Spitzer, where the fund companies benefited from having more assets under management in return for allowing late trades, are a possible explanation.

"As far as the market-timing goes, this was a ticking time bomb that the Security & Exchange Commission's enforcement division should have addressed years ago," says Mercer Bullard, president of shareholder advocacy group Fund Democracy. He says fund outfits could easily have eliminated market-timers' advantage by using what is known as "fair value pricing," in which funds' closing prices are adjusted to reflect any major events that occur after the underlying securities last traded.

TAKING ITS LUMPS. Some fund companies -- Portnoy mentions Vanguard and Putnam -- have done a good job at discouraging market-timing in their funds by using fair value pricing, putting redemption fees in place, or being extra vigilant when market-timers show up. Zitzewitz points out that fund companies with the lowest fees and the fewest insiders on their boards are typically the ones that do the best job of thwarting market-timers.

"The legal standards and duties regarding trading and valuation of mutual-fund shares are clear and longstanding," Matthew Fink, president of the industry's trade group, the Investment Company Institute, said in a Sept. 3 release. That may be true. Nonetheless, as a whole, the industry could have done a better job of discouraging market-timers. And now it has a big black eye, courtesy of Eliot Spitzer, to thank for its reluctance. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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