Special Report - Funds try last-minute makeovers
By James Paton
NEW YORK, Dec 28 (Reuters) - Mutual fund managers won't confess to using the tactic. But in the final trading minutes of 2001, some will be busy buying and selling shares in a bid to cover up recent stock-picking blunders.
The practice is known as ``window dressing.'' By scooping up winning stocks and ditching losers just before they're required to divulge their holdings to investors, managers can make their portfolios look prettier on paper.
The culprits, critics say, can trick investors into thinking that their funds have made wiser investment decisions. Managers engaged in this practice also rack up excessive trading costs that are passed on to investors, and some believe they undermine faith in the fund industry.
``I would have to say that there probably is more of it going on now than I ever imagined when I was running money myself,'' said Tim Schlindwein, the former chairman and chief executive of investment firm Stein Roe & Farnham, who worked as a fund manager earlier in his career.
Window dressing, experts say, occurs often and to different degrees. Yet regulators have warned managers not to get too comfortable. The industry's watchdog, the U.S. Securities and Exchange Commission, has said it is keeping an eye on the practice and that window dressing may violate antifraud provisions -- if it goes too far.
Managers are tempted, even though they cannot simply erase lousy results. By the time they finally latch onto the hot stocks or drop the cold ones, investors already will have missed out on the gains or suffered the losses.
Industry observers also worry about fund managers straying from their stated goals for at least part of a quarter or year, but then rearranging their portfolios at the eleventh hour to conform to their mandates.
``If for 89 days, a manager dances in ponds he doesn't belong in and then cleans up his act on the 90th day to put himself in line with his mission, that's not such a good thing,'' said Schlindwein, who now runs his own consulting company, Schlindwein Associates. ``Even if he got credible results, the buyers of these products are getting duped.''
YEAR-END SHENANIGANS
A more egregious offense is ``portfolio pumping,'' in which fund managers buy extra shares of stock they already own at the end of a quarter or a year to try to drive up stock prices and raise the value of their funds.
It's only a short-term fix, though. On the first day of the next period, managers unload those additional shares, typically dragging the value of those stocks lower.
But for a manager, whose bonus and reputation depends on end-of-the-year returns, there is clear incentive.
``Although the gains are given back the first day of the next year, that last little bit of performance will be used in determining your bonus, whether you cracked the top 10 or beat your benchmark,'' said Mercer Bullard, head of shareholder advocacy group Fund Democracy.
Bullard and others stress that forcing funds to disclose their holdings more often than twice a year -- the current requirement -- would hamper efforts to manipulate stocks.
They also have urged regulators to take a firmer stance against the practice. While pumping can benefit individual managers, it can mislead investors by luring them into funds with short-term performance that cannot be sustained.
Apparently the SEC is listening. Earlier this year, it censured ABN Amro (NYSE:ABN - news), the Dutch bank, and Oechsle International Advisors, a Boston investment firm, and fined each of them $200,000 in what it said was the first major case against portfolio pumping.
The SEC alleged that an ABN Amro trader and an Oechsle money manager in 1998 had agreed to manipulate shares of five European stocks to try to boost the value of stock accounts managed for Oechsle clients.
``The SEC has to be willing to take on cases like this, based on statistical analysis,'' Bullard said. ``In the past, they were never willing, but I think they should. It would send a much stronger message to the industry.''
GOING AFTER THE GUILTY
Punishing the perpetrators isn't so simple. Unless fund industry cops find a ``smoking gun'' exposing a manager's plot to artificially pump up returns, it's tough to prove anything fraudulent occurred.
``The problem is you don't really have any way of detecting it,'' said Don Luskin, an ex-fund manager who now runs TrendMacro, a Web site of stock market commentary. ``As with other forms of securities fraud, behaviorally it has the same content as legitimate activity. It's a crime of the mind.''
Window dressing also is hard to police. Managers can easily defend decisions to buy or sell certain stocks at a given time, said Luskin, who also ran the MetaMarkets funds, which constantly updated their holdings and trading activity online. The funds closed earlier this year amid shrinking assets.
``Fund managers are probably just rolling their eyes'' at attempts to stop window dressing, he said.
Those guilty of pumping or window dressing funds, experts said, are more likely found in the world of hedge funds, loosely regulated investment pools catering to the wealthy. Still, that's not to say it doesn't happen with mutual funds.
Heightened competition, the consultant Schlindwein said, has pushed managers to cross the line. But the investment companies that oversee the portfolios are as responsible as the managers themselves, he said.
``People have always tried to pursue superior returns,'' he said. ``But the climate is tougher. Managers are being driven to engage in these activities because of the huge pressure to produce. But their advisers have the ability to control it.''
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