Friday 7th November 2003
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Half of the biggest mutual funds let certain shareholders engage in "market timing" deals that are banned in their prospectuses.
Some 30% of fund managers admitted they gave sensitive portfolio information to privileged individuals.
This provides new evidence that the culture in the industry needs fundamental remedial behaviour modification. Managers ignore clear rules when profitable opportunities arise.
The core of the latest scandal broke some weeks ago when Canary Capital Partners, a hedge fund, was permitted by Janus Funds to trade its shares after the closing bell, and when it knew by international activity the fund was a "buy" or "sell" ("late trading").
Another practice is called "market timing" or "international fund arbitrage." This is when a fund announces its price at 4 o'clock in New York. Before the next morning, there are trades in international markets, and "timers" are permitted to buy into the fund the next morning at the previous day's price.
It is money for jam. Managers do not always mind it because they get activity fees and greater turnover. While some funds have "police" who watch for big, giveaway trades, it's alleged dozens of funds condone timing even though their prospectuses say it is not permitted.
Another allegation is that funds provided an up-to-the-minute record of their portfolio to hedge funds. Investors get told infrequently what they have shares in. Hedge funds know immediately and this improves their trading opportunities.
This malfeasance is being investigated simultaneously by a lot of heavy hitters. As 95 million Americans hold mutual funds, the issue is paramount in politics. Both the Senate and House are holding inquiries. So are the Securities & Exchange Commission and the State of Massachusetts.
New York's attorney general, Earl Spitzer, seems to be testifying at all the hearings. He is raising the heat by going beyond management to the board level. He believes boards condoned conflicts of interest in order to increase fee income.
"The governing structure has failed," he said, demanding chairmen have no contact with management or advisory boards.
Meanwhile, the scandal has claimed some big names. Richard Strong has resigned as chairman and CEO of Strong Mutual Funds.
Strong has $US47 billion under management and said it would not engage in market timing. It did.
Strong said he did it for his family and a few friends. One trusts these favoured individuals will visit Strong in the penitentiary, should that be his place of destiny. Spitzer will file criminal charges this week.
The attorney general has a good track record. Last year he spearheaded a ground-breaking investigation into Wall Street securities firms. This resulted in a $US1.4 billion settlement aimed at cleaning up research.
Spitzer found some Wall Street firms were recommending firms because of brokers' vested interests. Citigroup, for example, was obliged to separate its research and brokerage houses.
The biggest casualty is Putnam, the fifth biggest mutual fund with $US272 billion under management. It is alleged some managers allowed late and market timing.
The market has savaged it. State pension funds of Massachusetts, Rhode Island, Iowa and many teachers' pension funds have been withdrawn. The CEO has stepped down but many observers feel Putnam cannot recover. So far, it is the only firm facing criminal and civil law charges.
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