SEC Prepares to Battle Portfolio Pumping and Window Dressing
By Mercer Bullard
Special to TheStreet.com
8/16/00 1:43 PM ET
thestreet.com
LOL SEC had prepared for this kind of battle last few yrs. And they are ready for the battle 4 times a yr for the rest of this century.
Full article below:
==============================================
Editor's note: The author is the founder of Fund Democracy, a group that has petitioned the SEC to require greater disclosure of fund portfolio holdings.
In the wake of a Canadian settlement of a major portfolio fraud case, the U.S. Securities and Exchange Commission appears poised to send a message to fund managers who manipulate their funds' portfolios to mislead investors.
In July, the Royal Bank of Canada's investment management arm paid C$3 million to the Ontario Securities Commission to settle charges that it engaged in "high-closing trading." Known in the U.S. as portfolio pumping, high-closing trading is the purchasing of stocks that a fund already owns to give the fund a one-day performance boost at the end of a quarter. Extraordinary volume, particularly in a small-cap or thinly traded stock, can drive up the price of the stock and, in turn, boost the performance of the fund holding it.
Securities regulators in several Canadian provinces reportedly are following up the Royal Bank settlement by swamping Canadian funds with requests for trading documents. The Ontario Securities Commission has asked for trading records for Dec. 30 and 31, 1999, March 30 and 31, 2000, and June 29 and 30, 2000. The British Columbia Securities Commission also asked for transcripts of conversations relating to stock trades. The information requests appear to be part of a coordinated investigation by Canadian regulators to uncover more evidence of portfolio pumping.
Not to be outdone by the neighbors up north, the SEC staff is preparing its own portfolio pumping case. Earlier this year, Lori Richards, who heads the SEC's inspections program, established a task force to look into portfolio pumping. "We are focusing very hard on evaluating trading data that would indicate manipulation -- we're looking for signs that stocks may be manipulated at quarters' end to bump up performance," she explains.
New Year's Effect
If empirical evidence of widespread portfolio pumping is any indication, the SEC task force's inspections are likely to yield results. Based on his study of mutual fund returns, David Musto, a Wharton finance professor, found that top-performing funds generally posted their best returns on the last trading day of the calendar year and their worst returns on the first trading day of the new year. The hottest stocks generally peaked during the last hour of the last trading day of the year and dropped within 30 minutes of the opening of the next trading day. The same pattern applied at the end of each quarter.
Musto's findings are consistent with a 1997 study by Money magazine that showed that funds often beat the index based on their performance on the last day of the year. The study found that going into the last trading day of the year, 62% of the funds that lagged the S&P 500 index by as much as 25 basis points and 49% of the funds that lagged the market by as much as 50 basis points managed to beat the market for the year based solely on their last-day performance. For example, the Alger Small Capitalization fund's B share class lagged the market by 0.57 percentage points on Dec. 30, 1993, but it gained 3.08 percentage points on the last day of the year to beat the market for the year by 2.82 percentage points, Money found.
The Price of 'Pumping'
So what's wrong with fund managers trying to improve their funds' performances? For one thing, investors who invest at the end of a quarter, as pension funds often do, pay an inflated price for their shares. And portfolio pumping imposes wasteful trading costs on funds because any gains achieved are given up the following day. (It's no wonder that they don't include trading costs in their expense ratios!)
You also can argue that the buying and selling of stocks, not because they are good investments but in order to inflate fund performance results, undermines investors' confidence in the integrity of mutual funds. In her book, High-Flying Adventures in the Stock Market, journalist Molly Baker likens portfolio pumping to a "seemingly inordinate number of police ticketing speeders on the last day of the month, just to make a quota."
'Window Dressing' Also on Agenda
Portfolio pumping is not all the SEC task force will be targeting. "We're also looking for instances of managers window dressing their funds' portfolios to create a misleading impression of how the fund's assets were invested during the period," says Richards.
Window dressing is another common form of portfolio manipulation in which fund managers routinely buy and sell securities around public disclosure dates to hide their mistakes or to exaggerate their investing acumen. Wharton's Musto also studied this phenomenon, finding evidence that money market funds hold disproportionately more government securities just before, and disproportionately fewer just after, the dates on which the funds publicly disclose their portfolios in order to make them appear safer and more conservative than they really are.
For years, the SEC has been aware that U.S. fund managers engage in portfolio pumping and window dressing, but it has never sued a fund manager on that basis. Richards laments, "Proving that a fund manager bought a stock to manipulate the fund's performance would be, I think, extremely difficult, but not impossible." Without a smoking-gun memo in which a fund manager says the purpose of a trade was window dressing or portfolio pumping, proving a manager's corrupt intentions can be difficult.
Recent advances in technology have made it much easier, however, for the SEC to track fund trading patterns, which can provide statistical evidence of intent. Richards warns, "To the extent that these practices may exist, I believe that bringing just one enforcement action in this area would go a long way toward making fund managers think twice before engaging in these kinds of practices."
The SEC is also considering using disclosure reforms to attack portfolio fraud. Mutual funds are currently required to disclose their portfolios only twice a year, which some have argued facilitates portfolio pumping, window dressing and other forms of portfolio tampering, and deprives investors of the information they need to make informed investment decisions. These rules may be about to change.
My group, Fund Democracy, as well as the Financial Planning Association and 10 consumer groups led by the Consumer Federation of America, has petitioned the SEC to require funds to disclose portfolios more frequently. The AFL-CIO, representing more than 13 million union members, also plans to file a petition, and other groups are expected to follow suit. More frequent portfolio disclosure should make it even easier to tell which managers are engaging in portfolio shenanigans.
--------------------------------------------------------------------------------
Mercer Bullard, formerly an assistant chief counsel at the SEC, is founder and CEO of Fund Democracy, an advocacy group for mutual fund shareholders, in Chevy Chase, Md. |
