A cynical view of the recent mutual fund scandals. An excuse for the industry to screw investors even more?
by Sy Harding
MUTUAL FUNDS ALSO PLAYED DIRTY! November 7, 2003.
The scams, frauds, and scandals at corporations, brokerage firms, investment banks, and the stock exchanges themselves, weren’t a big surprise to me. I’ve been writing about such activities for years. Much of my 1999 book Riding the Bear warned of the schemes and scams of Wall Street, the fraudulent efforts to separate investors from a goodly portion of their investments, and the willingness of the SEC and regulators to look the other way.
But the mutual fund industry? It seemed so foolproof. A mutual fund simply buys stocks with the money investors send it, and at the end of each day adds up the total value of all its stock holdings, divides by the number of shares investors own at that moment, and that is the net asset value (NAV) of each investor’s shares. Every investor in the fund gets the same price. . . . or so we all thought.
But no, even in this branch of Wall Street, insiders and the largest players have been getting favored treatment at the expense of public investors. John Bogle, founder of the Vanguard group, and long-time critic of the mutual fund industry, estimates the unequal treatment has cost small investors $5 billion to $10 billion a year for upwards of ten years.
Two types of tricks have been identified so far.
The most obviously illegal is that numerous mutual funds allowed their favored customers, mostly hedge funds, to make trades after the market and the fund were closed to other investors for the day. So let’s say that Microsoft or IBM released potential market-moving news, perhaps bad earnings, after the market closed, news that everyone knew would cause the market to decline the next day. Since the market was already closed, if mutual fund investors decided to sell their mutual funds in anticipation of that market decline, they got the price of the fund at the end of the next day. However, favored customers were allowed to trade after the fund was closed, getting the fund’s price for that day, not sharing in the losses that would take place the following day.
Numerous mutual funds also apparently allowed favored customers, again mostly hedge funds, to trade in and out of their fund every few hours or days, while for public investors they enforced their rules that shares be held for a minimum length of time, usually two months, or fees for early exits would be levied.
What was in it for the mutual funds, to risk their reputations by participating in such schemes? The quid pro quo was apparently that they were rewarded with a larger percentage of a hedge fund’s assets, and got to charge the hedge funds extra fees for the special privileges.
If only it could be said that it was an isolated situation. But the SEC told lawmakers that so far they’ve discovered that 80% of fund families allowed after hours trading for favored customers, and 25% of brokerage firms with their own mutual funds allowed large customers to illegally trade in those funds after hours.
Eliot Spitzer, NY Attorney General, was once again out in front of the SEC and other regulators in uncovering the mess. He is demanding that U.S. mutual funds give back billions in illegal profits, and make sweeping changes to protect small investors.
Here’s a little prediction. In whatever rules they come up with to clean up the situation, the SEC and the mutual fund industry will also take advantage of the publicity surrounding the scandal to further penalize the victims, public investors.
Already the scams are being labeled as a ‘market-timing’ scandal. I predict that will be an excuse to diminish the ability of public investors to take their profits when they expect a market decline. Mutual funds want investors to simply buy and hold their funds, taking whatever losses come along. Mark it on the wall; The SEC and the mutual fund industry will use the ‘market-timing’ scandal, in which large customers were allowed to trade after-hours and in and out in a matter of hours or days, as an excuse to even further limit how often public investors can trade in and out of a mutual fund.
But they had better be careful. Already mutual funds that have been named in the scandal are seeing investors and institutions withdraw significant assets from their care. Meanwhile they are no longer the only game in town. They were already facing increasing competition from exchanged-traded-funds (ETFs), which trade on the stock exchanges.
ETFs have several advantages, including that they trade throughout the day, so that an investor can buy or sell them at any time, rather than only being able to get end-of-day pricing. ETFs also have no minimum holding period, and can even be bought on margin, or sold short.
So, it would behoove the mutual fund industry to not only clean up its act, but to improve its services to small investors. But I expect that instead they will use the label ‘market-timing’ scandal to twist the facts, as an excuse to further restrict services to individual investors.
Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.StreetSmartReport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market! |
