In our role as investment consultants, we often review historic events that seemed insurmountable at the time as a means to educate our clients. While many of our clients experienced the events of twenty years ago detailed in the paragraph below, all readers might appreciate a recap of what was a very unsettling time for financial markets.
September 3, 2003, was the date that one of the biggest scandals in the mutual fund world was exposed. Twenty years ago, the Attorney General of New York, Eliot Spitzer, accused a New Jersey hedge fund of engaging in unsavory trading practices with several mutual funds and brokerage houses. The scandal spread quickly with almost daily announcements of several company executives resigning by the end of the year. Below, you will find the memo that we sent to clients on November 11, 2002.
TO: Select Clients
FROM: The Associates of SIA
RE: Mutual Fund Scandal Perspective
DATE: November 11, 2003
In our 3rd quarter letter to clients, we highlighted the September 3rd announcement by the New York attorney general, Eliot Spitzer, of a formal investigation into the trading activities at several mutual fund companies. Since this announcement in early September, the Securities & Exchange Commission (SEC) and the attorney general of Massachusetts have started their own investigations into alleged trading abuses.
Also in our 3rd quarter letter, we assured you that we would follow the unfolding events and periodically provide you with an update of our perspective. We understand that the barrage of media coverage and almost daily announcements are extremely confusing and perhaps unsettling. We believe that this memorandum will give you an understanding of the issues to date and confidence in our assessment of them.
The mutual fund industry has grown to $7 trillion representing more than 90 million investors*. Most individuals own shares of mutual funds either directly or through company sponsored retirement plans. In an industry of this size, it is appropriate and necessary that legal authorities monitor the mutual fund companies for abuses that may harm long-term shareholders.
WHAT IS THE CURRENT CONTROVERSY?
The current controversy surrounding the mutual fund industry centers on reports of two types of trading: late trading and market timing. In the paragraphs below we define each type and provide a hypothetical example of how the trade could be conducted.
1. Late Trading is illegal and is conducted by an investor who attempts to move in and out of mutual funds quickly to take advantage of public information that becomes available after the markets close and when mutual fund net asset values are calculated at 4:00 p.m. Eastern time.
The allegation against those involved in late trading is that they were able to buy and sell shares after the 4:00 p.m. deadline which gave them an unfair advantage over other fund shareholders. An example of late trading could be:
At a 6:00 p.m. news conference, Microsoft’s Bill Gates announces a new development that will revolutionize the software industry. As a result of this new software, Microsoft expects a significant increase in earnings.
Knowing that mutual funds with significant exposure to Microsoft and other software companies are likely to increase in value when the markets open the next day, an investor allowed to engage in late trading has the opportunity after this 6:00 p.m. announcement to invest in prices determined at 4:00 p.m. his same investor sells the mutual fund shares at a profit the next day, thus diluting the profits of long-term shareholders.
Companies that have been named to date as participating in this type of illegal trading include Bank of America and approximately 25% of brokerage firms have indicated that they have been involved in late trading.
2. Market Timing is not illegal and is conducted by an investor who attempts to take advantage of security pricing that is out of synch with the value of a mutual fund’s underlying portfolio. Market timers often focus on international funds.
The allegation against those involved in market timing is that their quick and frequent movements in and out of mutual funds diluted the gains that belonged to long-term shareholders. An example of market timing could be:
When Asian markets close, it is 3:00 a.m. in the United States. The international securities in a US mutual fund are priced based upon information at that time. At 2:00 p.m. that same day, the Federal Reserve announces a significant drop in the Fed Funds rate and the US markets soar to close at 4:00 p.m. with a 5% gain for the day. Investors expect that foreign countries will lower their interest rates too.
In this hypothetical example, an investor allowed to engage in market timing has the opportunity to invest in securities priced in Asia 13 hours earlier, knowing that the Asian markets are likely to increase in value when they open the next day. This investor quickly sells the shares at a profit, thus diluting the profits of long-term shareholders.
This type of trading has attracted the attention of the media because companies that have been named to date include the well-known mutual fund families of Putnam, Strong, Janus and Alliance. In addition, some of these firms have disclosed that some of their own investment managers have admitted to engaging in market timing activities within their own mutual funds.
WHAT DOES THIS MEAN TO INVESTORS?
There is no doubt that the recent mutual fund scandal is again testing investors’ faith in the investment industry. During the past two years the profession has come under intense scrutiny. Throughout the summer of 2002 investors dealt with the disclosures of many accounting and corporate scandals. However, as the number of announcements subsided, investors grew more confident and the recent stock market rally began in the fall.
2003 may be remembered for its own scandal, but so far the stock market has not declined as a result of the mutual fund scandal. Investors have chosen to focus on a rebounding economy and have pushed stock prices higher. Many of the mutual fund companies named in the scandal have seen significant withdrawals from their mutual funds, but it appears as if investors have put their money back into the mutual funds of other companies.
Academics are busy calculating the “cost to shareholders” resulting from higher trading commissions and dilution of profits that were a result of these trading schemes. Once calculated, the mutual fund companies have said that they will reimburse the specific mutual funds. However, given the $7 trillion invested in mutual funds and the relatively few number of mutual funds affected, the amount may be pennies per shareholder.
HOW DO WE TRY TO PROTECT OUR CLIENTS?
In our role as your investment advisor, our mutual fund selection process has always included both quantitative and qualitative criteria to ensure that we have placed your money in the hands of managers that align their interests with yours. A few of these criteria include our insistence that:
- the mutual fund charge reasonable annual expenses.
- management has a proven commitment to close a fund to new investors if the asset base becomes too large.
- the corporate culture does not promote excessive marketing of investment performance.
- the management team invests in their own mutual funds.
- the mutual fund company does not add new funds because of popular trends.
- management agrees to provide open and honest communication with us.
While we believe that these and many other criteria have kept your mutual fund holdings from being implicated in the scandal so far, we would be naïve to expect that the continuing investigations into late trading and market timing of mutual fund shares will not uncover more instances of abuse.
WHAT WILL HAPPEN NEXT?
To date, the only assessable damage has been the tarnishing of brand images such as Putnam and Janus and a few high profile people who have lost their jobs. Many individuals have plead guilty or have been indicted on charges of wrongdoing, however, no mutual fund company has been charged with a crime or paid a fine.
We caution investors not to be short-sighted by condemning a whole industry for the illegal, unethical and greedy acts of a few. Most mutual fund companies accept the obligation to protect all shareholders by not allowing late trading and by monitoring and discouraging investors from conducting market timing transactions.
Government agencies and Congress are working on ideas to eliminate abuses in the mutual fund industry. We are confident that any changes made to the rules regarding the mutual fund industry will be in the best interest of our clients and all mutual fund shareholders.
We remain committed to analyzing these issues and conveying our thoughts to you in written as well as oral communication. We look forward to our next meeting with you, however we are always available in the interim should you need to speak with us.
Best of luck in your preparations for the holidays.
*Source: Fortune Magazine, November 2003