Mutual-Fund Scandal Clouds Bottom Lines

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Mutual-Fund Scandal Clouds Bottom Lines

'Dilution' Costs to Shareholders Could Be Large and the Target Of Regulators' Recovery Efforts

By Tom Lauricella, The Wall Street Journal

October 20, 2003

How much is the mutual-fund scandal going to cost mutual-fund companies?

Before it's all over, the bottom lines of mutual-fund companies could be in for some larger hits than are widely expected at this point. One reason is that investigators are focusing on how much "dilution" shareholders suffered in their fund holdings as a result of the short-term trading. That figure could end up totaling many hundreds of millions of dollars -- money that regulators are likely to try and take out of the coffers of mutual-fund companies.

For now, with investigations into abuses involving the trading of fund shares still far from complete, it is impossible to put a price tag on the biggest scandal to hit the fund industry in decades. A first stab at estimating the cost for just one company was taken by Bank of America last week, which said it was setting aside $100 million to pay for legal fees and other scandal-related expenses, as well as an undisclosed amount in restitution for fund shareholders.

Janus Capital Group, another fund group mentioned prominently in the scandal investigation by New York Attorney General Eliot Spitzer, also has given an early figure on at least some of its expected costs. The firm pledged to pay fund investors all the management fees it earned on the money from rapid-trading hedge funds, a figure that Wall Street analysts peg at about $1 million.

Even so, add it up and the damage to mutual-fund companies from the share-trading scandal so far has been largely contained to tarnished reputations and a few lost jobs. Individuals have been indicted or pleaded guilty to wrongdoing, but no mutual-fund company has been charged with a crime nor paid any fines. Indeed, much of the attention on the expenses stemming from the alleged trading abuses -- such as higher trading commissions and costs linked to disrupting the management of portfolios -- involve figures that aren't particularly large for an industry that generates fees from overseeing $7 trillion in total fund assets.

Of course, there are other costs to the firms ensnared in the scandal, most notably the impact of fund redemptions by investors. Janus, along with funds run by Bank of America, Bank One and Strong Capital Management -- all of which were mentioned in Mr. Spitzer's complaint -- suffered investor withdrawals in September totaling $7.9 billion, or about 1.85% of their total assets, according to Lipper Inc. And in the case of Janus, there is also the battering inflicted on the company's stock, which has fallen just over 21% since the investigation was unveiled Sept. 3.

But dilution is likely to be the primary issue when it comes to reimbursing shareholders. It is a complex and unfamiliar term to most investors, but it boils down to a simple notion: The profit made by short-term traders of mutual-fund shares known as market timers is often money lost by long-term shareholders. Because money placed in a fund by a short-term trader was often just held as part of the portfolio's cash holdings and never invested in the market, there's a very close correlation between the market-timer's profits and the precise amount of money skimmed out of shareholder's accounts, investigators say.

"The fund companies take the position that there were no transactions costs since the timers did it all out of the cash holdings and there was no disruption," says David D. Brown IV, an assistant attorney general in New York involved in the state's fund investigation. "But if a timer goes in and out of a fund in a day or two and makes a million dollars, where's that money coming from? In that case his profits can be exactly equal to the dilution."

That notion has supporters among academics and some fund-industry leaders. "Even if the portfolio manager says they are not being disrupted, there is going to be the dilution," says Paul Haaga, chairman of the Investment Company Institute, the industry's main trade group, and an executive vice president at Capital Research & Management, which oversees the American Funds group.

The trading in question is a rapid-fire form of buying and selling of mutual funds known as market timing. These timing trades seek to take advantage of short-term dislocations between the price of a mutual fund's shares and the value of its underlying securities. Market timers often focused on international funds because the prices on the stocks held by those funds are generally hours out of date when funds set their share price at 4 p.m. Eastern time and would typically own only a few funds for a few days.

Here's an explanation prepared in 1997 by the Securities and Exchange Commission illustrating how dilution hurts long-term investors of a mutual fund. Assume that an international stock fund in the U.S. holding Asian stocks has starting assets of $50 million and five million shares outstanding, resulting in a share price, or net asset value, of $10. A hedge-fund trader sees that Asian stock prices declined 10% in the latest day's trading, meaning that the international mutual fund is likely to reduce its share price by a similar amount to $9 when it sets its next NAV at 4 p.m. Eastern time.

But the trader also sees that since Asian markets closed hours earlier, some positive news has come out that is likely to boost Asian stocks when they reopen for trading tomorrow. So the trader spends $10 million to buy 1.11 million fund shares at $9 each today. If the Asian shares revert to their starting level the next day, the portfolio will have assets of $60 million and the trader can sell his shares at the new NAV of $9.82.

That gives the trader proceeds of $10.9 million on his $10 million investment. Meanwhile, other investors in the fund who didn't trade any shares would see their NAV drop by 18 cents, or a total reduction in their portfolio value of $900,000. The money gained from short-term trading "comes dollar for dollar at the expense of fund shareholders," says John C. Bogle, founder of Vanguard Group.

No one yet can put a final number on the dilution suffered by shareholders in funds where certain investors were allowed to carry out timing trades but other investors weren't. But investigators say it is possible to get a fairly accurate measurement on the amount of dilution that shareholders of individual funds have suffered.

For example, investigators have done some rough calculations on a mutual-fund family that had an arrangement with a market-timer to permit short-term trading of one of their funds. Neither the fund family nor the timer were identified by the investigators but they said over a three-month period, the timer made eight short-term trades. The fund kept about 3% of the portfolio in cash and the timer was allowed to trade up to 1% of the fund's assets. Because the timer's money was only in the hands of the fund for a few days and essentially became part of the portfolio's cash holdings, that money was never invested.

During this period, the timer made an estimated $1.1 million in profits, money that came directly out of the cash holdings of the portfolio and thus investors' pockets, the investigators contend.

The concept of dilution is nothing new. Minimizing shareholder dilution was at the heart of rules governing fund-share pricing in the Investment Company Act of 1940, the legislation that essentially created the mutual-fund industry as it exists today. In 1968, the SEC made adjustments to fund-pricing rules, aiming to minimizing dilution. In 1997, the SEC examined the impact market timers had on international stock-fund shareholders following the collapse of the Asian stock markets. The SEC example on how to calculate dilution was part of an effort by the agency to encourage funds to make greater use of so-called fair-value pricing -- a tool to eliminate the stale prices that make market timing profitable.

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