For Staid Mutual-Fund Industry, Growing Probe Signals Shake-Up

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For Staid Mutual-Fund Industry, Growing Probe Signals Shake-Up

Investigators Find Indications Of Widespread Abuses Hurting Small Investors

By Tom Lauricella, The Wall Street Journal

October 20, 2003

The mutual-fund scandal is spreading, as it becomes clear that players throughout the $7 trillion industry could face scrutiny for improper practices that are turning out to be surprisingly common.

On Thursday, Massachusetts securities regulators signaled that they are investigating whether employees at three big mutual-fund companies -- Fidelity Investments, Morgan Stanley and Franklin Resources Inc. -- helped brokers get around prohibitions on short-term trading in their funds. The same day, state prosecutors in New York who have spearheaded a growing criminal investigation of the fund business, notched their first conviction of a mutual-fund executive: a former senior official with Fred Alger Management Inc., who pleaded guilty to obstructing the probe.

New York Attorney General Eliot Spitzer, having earlier forced changes in the way analysts at brokerage firms operate, now says he intends to use the mutual-fund investigation to clean up another part of the financial world that has favored large clients at the expense of smaller ones, including millions of workers and retirees. The Securities and Exchange Commission, scrambling to keep up with him, as it did during the investigation of Wall Street analysts, is now filing civil suits of its own and is considering possible new rules aimed at preventing misbehavior in mutual-fund trading.

Industry heads have begun to roll. Top mutual-fund executives at Bank of America Corp. and Bank One Corp. have lost their jobs because of allegations of questionable rapid trading at those firms. Alliance Capital Management Holdings LP suspended a veteran portfolio manager who ran one of the country's largest technology-stock funds.

The widening debacle -- which could shake investor confidence and lead to significant changes in mutual-fund rules -- is rooted in a paradox that has dogged the industry since its birth nearly 80 years ago. The central attraction of mutual funds is that they offer the opportunity to buy shares in a single investment that reflects the composite value of dozens, or even hundreds, of individual securities.

The chance for rapid speculative profits arises from the common mutual-fund practice of assigning a value to fund shares only once a day, usually at 4 p.m. Eastern time. But the value of the securities those fund shares represent changes continuously. That means that fund-share prices often are out-of-sync with the underlying assets -- a discrepancy that big, sophisticated investors can exploit. Technological advances and the globalization of markets have opened many more such opportunities.

The big investors' quick profits from these games ultimately come out of the pockets of longer-term shareholders. Regulators and class-action lawyers are expected to try to recover these shareholder losses in legal actions that could cost fund companies hundreds of millions of dollars. (See related article)

The mutual-fund industry has wrestled with the pricing paradox for generations. In the 1930s, many mutual funds effectively had two prices: one that was public and another, more-up-to-date one that was made known hours before it was published to certain big investors. Those in the know could make quick profits because they knew where fund prices were headed. The Investment Company Act of 1940 eliminated this blatant unfairness by requiring funds to stick to a single public price, among other rules that created the modern mutual-fund industry.

In 1968, the SEC tried to fine-tune pricing rules because it found long-term shareholders were still being harmed by the quick-hit tactics of some large traders. Today, if you buy fund shares after 4 p.m., you pay the price set the following day.

But over the past six weeks, the investigations by Mr. Spitzer and others have brought to light that there is still plenty of room to game mutual-fund prices. Even more shocking and potentially damaging are the allegations that some fund employees have gone out of their way to help big investors unfairly lock in quick, short-term profits. In exchange, fund executives allegedly have asked short-term traders to make separate, longer-term investments on which the fund companies earned healthy management fees.

"This seems to be the most egregious violation of the public trust of any of the events of recent years," says Arthur Levitt, a former SEC chairman. "Investors may realize they can't trust the bond market or they can't trust a stock broker or analysts, but mutual funds have been havens of security and integrity."

One major question as the probes expand is how many of the 95 million mutual-fund customers will be so shaken that they redeem their shares. After a wave of scandals ranging from accounting fraud at major corporations to stock-hyping by major-brokerage analysts, some investors appear to be reacting to the burgeoning mutual-fund imbroglio. Four firms whose employees were said by Mr. Spitzer to have allowed improper short-term trading -- Bank of America, Bank One, Janus Capital Group Inc. and Strong Capital Management Inc. -- saw investor withdrawals in September totaling $7.9 billion, or 1.85% of their total assets, according to fund analyst Lipper Inc. Stock funds overall enjoyed net inflows of $19.5 billion last month, Lipper estimates.

In that civil case, Mr. Spitzer alleged that Edward J. Stern, a managing principal of Canary Capital Partners LLC, a hedge fund, had arranged with the mutual-fund companies to trade their shares after the 4 p.m. deadline. Mr. Stern and Canary agreed to pay a total of $40 million to settle the complaint without admitting or denying wrongdoing. State and federal investigators say that a number of hedge funds -- lightly regulated investment pools that cater to wealthy clients and use a variety of money-making strategies -- frequently engage in improper mutual-fund trading.

Two Strategies

Two types of short-term fund trading have emerged from current investigations: late trading and market timing. Late trading of the sort allegedly done by Canary is flat-out illegal according to Mr. Spitzer's office and other regulators. A late trader takes advantage of buying at the 4 p.m. price when events indicate that price is already obsolete. For example, if by 6 p.m., it appears that stock markets around the world are rising, a trader can purchase shares of a stock mutual fund at today's 4 p.m. price confident that those shares can be sold on the following day at a higher price, or "net-asset value," in mutual-fund parlance. Ordinary investors not able to engage in late trading would have to wait to act on the rising markets until the next day.

Mr. Spitzer has alleged that Canary had a late-trading agreement with Theodore Sihpol III, a Bank of America broker. Canary allegedly could place orders during the day to buy and sell shares in Bank of America mutual funds, but the orders wouldn't be officially submitted to the funds until after 4 p.m. According to a criminal indictment of Mr. Sihpol, the broker would receive a phone call after 4 p.m. from Canary employees, telling him which of the trade orders the hedge fund actually wanted put through. Mr. Sihpol, who has been charged with grand larceny and securities fraud, would pass along only those orders -- which carried a pre-4 p.m. time stamp, making them appear legitimate, according to the indictment. Mr. Sihpol, who has been fired by Bank of America, has pleaded not guilty.

Market timing, the other form of short-term trading, isn't illegal. But most mutual-fund companies have written policies, by which they are legally bound, that say they at least try to discourage the practice. To illustrate: A market timer in the U.S. could gain an advantage after foreign markets have fallen. Because of time differences, the foreign results will depress the prices of international-stock mutual funds on the following day in the U.S. But on that following day, the market timer may observe U.S. stocks rallying and predict that foreign markets will likely rise as well. The trader can then buy shares of an international-stock fund at the depressed price, planning to turn around and sell for a quick gain the next day.

Most mutual funds say they try to deter market-timing by refusing to accept orders from rapid-fire investors or charging them extra fees. Fund companies that have permitted such trading -- and especially those that have encouraged it -- could face allegations of failing to protect the interest of all of their shareholders. James Connelly Jr., a former executive with the Alger Management mutual-fund firm, allegedly permitted large investors, including a Texas hedge fund, to move quickly in and out of Alger funds. Alger generally prohibited other investors from market-timing trades. Apart from pleading guilty to the state obstruction-of-justice charge, Mr. Connelly has paid a $400,000 civil penalty to settle SEC allegations that by allowing some investors to time their trades in this manner, he violated his fiduciary duty to protect other investors. Mr. Connelly neither admitted nor denied the SEC allegations. Alger said it is cooperating with state and federal investigators.

Late trading and market timing hurt longer-term, less-active shareholders, according to the SEC, Mr. Spitzer and others. That's because a mutual fund is a finite pool of assets. If one investor is permitted to cash out a quick profit based on a fleeting discrepancy between the fund's net-asset value and shifting securities prices, the cash has to come from somewhere. Normally, the fund would pay out of its cash holdings or sell securities to generate the money. Either way, the payout diminishes the overall pool, and other shareholders are hurt.

In addition to this "dilution" effect, as it's known in the industry, rapid short-term trading can raise a fund's transaction costs: the expenses of actually buying and selling securities in response to a hedge fund moving in and out of the mutual fund. Since transaction costs generally are shared by all of a fund's investors, the higher expenses become another penalty imposed on long-term shareholders.

For the speedy traders, on the other hand, short-term shuffles can be quite lucrative. Mr. Stern's hedge fund, Canary Capital, generated returns of 28.5% in 2001, a year when the Dow Jones Industrial Average lost 7.1%.

Jason Greene, an associate finance professor at Georgia State University's Robinson College of Business, co-authored an April 2000 study that found that over a five-year period that ended in 1999, a market-timing strategy returned an average of 34.2% annually, nearly three times the returns an investor would have earned by buying and holding the same funds.

Mutual funds are willing to accommodate market-timers and late traders because of the other business these generally large investors generate. In a number of cases, Mr. Spitzer has alleged, fund companies have agreed to allow short-term trading of specific funds in exchange for longer-term investments the traders placed in other funds.

At Janus Funds, e-mails made public by the New York attorney general apparently indicate that sales executives at one point earlier this year debated whether to violate the funds' prospectus rules before deciding to assist with timing trades. "We won't actively seek timers," one e-mail said, but when market-timing business could mean "increased profitability to the firm," Janus would "make exceptions." Some of the alleged wrongdoing went beyond simply profiting at the expense of fund shareholders. At Bank of America, some employees helped Canary make investment bets against the stocks owned by the firm's mutual funds, according to Mr. Spitzer. By facilitating this "shorting" of stocks, Bank of America was potentially helping to drive down the value of investments of its own long-term shareholders.

History Lessons

Since the first mutual fund, the Massachusetts Investors Trust, opened its doors in March 1924, most mutual funds have calculated their share price once a day based on the close of market trading. In the days long before computers, many funds publicly announced their price the following morning at 10 a.m. However, some mutual-fund insiders, along with big investors who had been tipped off, knew prices the previous evening and could trade on the information.

The Investment Company Act of 1940 did away with that particular abuse by requiring one official price. But by the bull market of the late 1960s, another weakness had become evident. At that time, most funds calculated their share price and then allowed investors to buy and sell shares at that price for the next 24 hours.

This "backward pricing" meant that net-asset values were usually out-of-date. Big investors, who because of their size could buy funds without paying the large up-front sales charges common at the time, would acquire large amounts of mutual-fund shares during a rallying market and sell quickly after the fund's shares were repriced and reflected the market's gains. This practice, just like the market-timing of today, diluted the profits of long-term investors.

In 1968, the SEC mandated that mutual funds reverse their policies to today's "forward pricing," under which investors get the next day's net-asset value if they place orders to buy or sell shares after 4 p.m.

The opportunities for more investors to market-time funds grew during the 1990s, as markets boomed and more funds were offered. Greater electronic availability to market data world-wide also created more ways for sophisticated investors to profit from short-term fund trading.

Some fund companies have fought back. Vanguard Group, for example, imposed penalties and restrictions on short-term traders, even going so far as to bar investors from making trades in some of its index funds between 2:30 p.m. and 4 p.m. That is when most market timers place their bets.

SEC Chairman William Donaldson this month said the commission would consider adopting a rule that would require all fund-share orders to be in the hands of fund companies by 4 p.m. That move would also make it more difficult to conduct short-term trading in the mid-afternoon.

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