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Market timing is a technique involving short-term, "in and out" trading of mutual fund shares, which harms the long-term shareholders for whom mutual funds are designed. Market timing is a widespread practice, and the dilutive influence on investor returns has been measured in several academic studies - some of them mentioned in a seperate article on this page. Late trading is a practice that permitts favored investors to buy fund shares at the daily 4 p.m. price after the market closed at that time. Spitzer compared that to allowing a favored few to place bets at the racetrack after the horses cross the finish line. When any such thing happens, it's plain to see how everybody's interests may be compromised. Spitzer said fund companies including Bank of America, Bank One, Janus and Strong Capital Management gave special trading opportunities to the hedge fund Canary Capital Partners. [Canary Capital agreed to relinquish $30 million in illicit profits and pay a $10 million penalty to settle the allegations.] "The full extent of this complicated fraud is not yet known," Spitzer said in a statement. "But one thing is clear: The mutual fund industry operates on a double standard. Certain companies and individuals have been given the opportunity to manipulate the system." [From CBS MarketWatch 9-5: Janus Capital Group acknowledged late Friday that it permitted "discretionary market-timing arrangements" in some of its funds and said it would reimburse fund shareholders for any losses they may have suffered.] [From Smith & Lauricella, WSH 9-8: In its announcement Friday, Janus said that following an internal review, it had identified investments totaling about $750 million, or 0.5% of its $150 billion in assets under management, by timing traders. The complaint against Mr. Stern alleged that Janus gave permission for his hedge fund to time Janus Mercury and High Yield funds.] Everybody Does It Lauricella, Solomon & Oster, WSJ 9-05 Some traders say hedge funds, which are loosely regulated investment pools, long have participated in "timing" trades for fast profits, with mutual funds' approval. "Everyone has been doing this trade," says Stan Jonas, managing director of Fimat USA, a derivative trading firm that is a subsidiary of Societe Generale. "It has been the biggest layup in the last five years." Millennium Accused Lauricella, Solomon & Oster, WSJ 9-05 In confirming it had received a subpoena for information, a spokesman for Millennium, one of the largest hedge funds, said the firm "did not engage in after-hours trading as described in that complaint" by Mr. Spitzer. As one of its numerous strategies, Millennium does carry out permissible timing trades in mutual-fund shares, allocating as much as $1 billion to that arcane trading area, according to people familiar with the fund. At times, the strategy returned 25% and accounted for as much as $250 million in profits, a huge part of the fund's performance, these people say. More Subpoenas Sender/Cohen/Zuckerman/Mollenkamp, WSJ 9-09 The New York attorney general has subpoenaed as many as 11 other hedge funds, including Bermuda-based Tewksbury Capital Management, Haidar Capital Management LLC, and Samaritan Asset Management. The actions underscore that the scope of the burgeoning investigation is broadening to include additional hedge funds. Morningstar's Reaction Christopher Oster, WSJ 9-15 Morningstar said Friday that it no longer is recommending any funds managed by Bank of America Corp., Janus Capital Group Inc., Bank One Corp. or Strong Capital Management Inc. Morningstar isn't changing its influential star ratings on the funds, which many investors and advisers use to help choose funds. But its written commentary on the affected funds will be changed to reflect Morningstar's negative opinion in the wake of investigations into trading abuses.
There's a lot of buckshot in this question. Morningstar has come out and, through its top four fund analysts, said that investors need to head for the exits until the firms in the Spitzer complaint can prove that they are putting shareholder interests first. I'll say the same thing once I am certain it is warranted. Did the actions in the case hurt my fund? If you invested in an ordinary domestic growth fund, there's little chance you were affected. The market timing trades that the fund groups were supposed to prohibit but allegedly allowed involved international and foreign stock funds. The fund firms have talked about returning money to investors. I own funds with those companies. What will I get back and how do I get it? Three of the fund firms - Strong is the exception - have said they will make restitution for any losses investors suffered due to heightened costs created by the market-timing trades. That means it won't be a lot of money, and it will only be for investors in the funds where the trades were made. You should get the money automatically, but you may still want to join in the class-action suits that have been filed over the allegations. I sold my funds in one of these firms a year ago. Will I still be entitled to restitution? That depends on when and how you owned the fund and when authorities determine that the trading rules were broken. If you owned the kind of fund affected by the trades during the time when the rules were broken, you should be eligible for your share of any restitution monies. You certainly could be part of any class-action case on behalf of shareholders. But if you held the fund in a brokerage account - rather than investing directly with the company - you may have to file a claim in order to get your share of the restitution monies; that will become clearer once restitution details are determined.
Bank of America, according to the complaint, gave hedge fund manager Edward Stern of Canary Capital Partners a terminal that allowed him to enter orders until 6:30 p.m. Another institution, Mr. Spitzer said, allowed Mr. Stern to trade until 9 p.m. at the 4 p.m. price. What happened when such trades were made? If Mr. Stern knew that prices were likely to rise the next day, that meant that he could buy at a low price and sell at the high one. The fund could not, of course, invest the money at the lower prices. The result was that all other shareholders in the fund did a little worse than they otherwise would have. They were the losers. For most funds, it is not possible to bet on a decline in prices. But Bank of America went way out of its way to give Mr. Stern the ability to do that. It provided him with detailed, current information on the funds' holdings and then sold him derivative securities that let him take short positions in the basket of stocks owned by the fund. Such information on fund holdings was not available to other investors. As a result, Mr. Stern could buy shares of the fund and simultaneously short the stocks in it. That left him with a neutral position. Then, if he learned news at 6 p.m. that made it appear likely the market would fall the next day, he could sell the fund shares he owned, leaving him with a net short position. The next day, he could buy back the fund shares at a lower price. Why did Bank of America agree to all this? It was making good money on various aspects of the transaction - money that Mr. Stern could afford to pay because he was being allowed to make investments that were all but sure things. Only the other fund shareholders suffered. More Information From Dan Ackman, Forbes 9-5: Stern's father, Leonard Stern, is a billionaire real estate developer whose name adorns the New York University business school. The hedge fund was called canary because the family fortune was based on the Hartz Mountain pet food company, which got its start by selling canary feed. From Bank of America broker named Theodore Sihpol III in article by Carrick Mollenkamp, WSJ 9-5: The Stern family had a "total net worth of approximately $3 billion, & is the 11th richest family in NYC." From Ian McDonald, WSJ 9-09: Despite steady stock-market losses over the past three years, Mr. Stern's hedge-fund returns were eye-popping. Canary posted gains of 50%, 29% and 15% in 2000, 2001 and 2002, respectively, after deducting management fees. The Standard & Poor's 500-stock index lost a cumulative 40% of its value over that period. The STC Connection Lauricella, Solomon & Oster, WSJ 9-05 While just four mutual-fund companies are named as part of the New York attorney general's lawsuit, Canary potentially had access to trading with thousands of different funds through the facilities of Security Trust Co. of Phoenix. STC provides an electronic system to handle mutual-fund trades for participants in retirement plans as well as institutional investors and financial advisers. Mr. Spitzer alleged that STC gave Canary the ability to trade funds as late as 9 p.m. Eastern time at prices that shouldn't have been available after the 4 p.m. close of market trading. Such trades were so profitable to Canary that STC eventually demanded and received 4% of Canary's gains, Mr. Spitzer charged.
As a result, the fund-trading investigation has focused on financial-services intermediaries such as Security Trust as potential weak links in the way mutual-fund companies police the trading of shares in their funds. No matter how strictly fund firms crack down directly on rapid-fire traders, the fund companies must also rely on many small firms such as Security Trust that have the ability to trade funds - or let others trade them - in ways that breach normal fund-company rules followed by other investors. Security Trust, which wasn't named as a defendant by Mr. Spitzer, says that Mr. Stern was its only hedge-fund client. Canary orders were bundled with other legitimate orders being forwarded to fund companies by Security Trust. While Canary had trading arrangements with several fund companies, Mr. Spitzer said, Security Trust offered a vast menu of funds for Mr. Stern to trade. Starting in May 2000, the company gave Canary the ability to trade as late 9 p.m. Eastern time in hundreds, and potentially thousands, of funds. Critics say the problem with the behind-the-scenes trading systems go beyond Security Trust, and that fund companies have long kept too loose a grasp on policing trades.
Say a mutual fund investing in European stocks has only four shareholders who each own one share. The total value of the funds assets is $40 and the fund's net asset value per share (set once a day at the close of trade in NYC) is $10 on Monday ($40 per share divided by 4 shareholders). At 2 p.m. ET Monday, out omes some good news likely to push share prices higher by 25% when trading resumes in Europe Tuesday. But your fund's NAV Monday does not yet reflect this good news because it's based on share prices at the close of European trade, which occurs several hours before Wall Street shuts down. The fund's shareholders might expect their NAV to rise 25% on Tuesday to $12.50 a share. Then the fund's total value would be $50 ($12.50 per share x 4 shareholders). But they'll get less if a market timer or late trader steps in. Say the market timing trader senses prices will go up and decides to buy a share of the fund at Monday's NAV of $10. Tuesday rolls around, and prices rise along with the fund's NAV. With the trader's late-day investment Monday plus the boost in share price, the fund's total value comes to $60 ($50 after 25% rise in share price + $10 cash investment from the trader). With the trader, there are now five shareholders in the fund, so each fund share is now worth $12 ($60/5), instead of the $12.50 the four original shareholders were expecting. The short-term market timing trader will sell his share on Tuesday for $12, booking a $2 profit. That's the equivalent of 50 cents a shareholder ($2 divided by 4) - which is the same amount forfeited by each of the original shareholders because of the trader's actions. Instead of getting the 25% increase in NAV they were expecting, the shareholders only see a 20% increase. The percentage that the market timers dilute from the fund is equal to their share of funds shares. To make this a more real life example, make that percentage of share ownership half of one percent, make the daily gain 2%, then repeat this process about 40 times a year.
In 1981, Putnam won permission from the SEC to use a form of fair-value pricing for its international funds. But Putnam, like most other companies, used the practice mostly for highly unusual events, perhaps only a handful of times a year. Fidelity Investments, the nation's largest mutual-fund company measured by assets, raised eyebrows in 1997 when it used fair-value pricing for international funds during the Asian financial crisis. Fidelity drew howls from traders, but the SEC later supported Fidelity's approach. In 2001, the SEC put the fund industry on notice that it must adopt fair-value pricing for "significant events" in the market affecting stock values. Lori Richards, the SEC's director of examinations, said the industry's response to the agency's letter requiring fair-value pricing has been "a mixed bag," with larger fund companies generally adopting fair-value policies. But she said many smaller companies have received deficiency letters, citing them for failing to adopt fair-value practices. In a study released in January, consulting firm Deloitte & Touche LLP found that 81% of mutual-fund firms had established policies related to fair-value pricing. But 30% had made no adjustments at all to the stock prices of their foreign securities over the past year. And more than half had made fewer than six revaluations -- far fewer than many experts recommend to deter timers.
Some experts are questioning internal policing mechanisms within these firms given the widespread access to the questionable mutual fund flow data. "This is the sort of statistic that everybody in the firm should see, and somebody should be asking questions," said Jim Atkinson, CEO of Guinness Atkinson Funds. Independent trustees would have a difficult time detecting market-timing activity by analyzing inflow/outflow data because they do not analyze this information on a daily basis. Sharp daily movements should be balanced out over a quarter. Nations' International Equity Fund's average shareholder redemption and purchase levels hovered at 8% before the 2000-2002 period in which the late-trading activities allegedly took place. After 2000, the International Equity Fund's average monthly redemptions and sales rose to 25%, according to FundExpenses.com, and remained at above-average levels for more than a year. The turnover of Janus' Advisor International Growth Fund's shares jumped from 10% in mid-2001 turnover to more than 30% at the end of 2002. In addition, in mid-2001, the turnover of Janus' Worldwide Fund's shares rose from 5% to 12% by the end of 2002.
The confluence of too many players, a bone-crushing bear market, and tapering demand left a vast crop of firms battling over what suddenly seemed like a trickle of money. That's led many to bend over backwards trying to woo higher-net-worth individuals and institutions, typically the most stable and profitable clients. Firms have taken steps to reach out to higher-net worth retail investors. One avenue is separately managed accounts - that are essentially personalized versions of their mutual funds, with the promise of more personalized service and tax-sensitive trading. At the end of June, separate accounts were home to more than $440 billion, up from about $289 billion at the end of 1998, according to FRC data. Many fund shops have also launched their own hedge funds. Many firms have also raised their funds' investment minimums, while others have created new share classes with lower expense ratios, such as the Vanguard Group's "Admiral" shares, for shareholders with large and/or long-held accounts. At its start of the 90's, there were fewer than 3,000 funds with $981 billion in total assets, according to figures from ICI. By the end, the industry managed $6.8 trillion, among nearly 7,800 funds. But then the bear market shaved nearly $1 trillion from stock fund assets. That adds up to about $15 billion less in annual fee revenue. It's against this grim mix of business events that unpalatable deals, as charged in Mr. Spitzer's complaint, allegedly started to surface. As Mr. Spitzer and federal regulators partner up to probe practices at the nation's 80 largest fund firms, they may find that growing competitiveness has made these misdeeds more prevalent than many realize.
`There are three major reasons why large size [in a mutual fund] inhibits the achievement of superior returns,' writes Jack Bogle in his book `Common Sense on Mutual Funds'. `The universe of stocks available for a fund's portfolio declines; transaction costs increase; and portfolio management becomes increasingly structured, group-oriented and less reliant on savvy individuals.' Higher transaction costs? `The larger the number of shares traded, the greater the impact on price,' Bogle says. Running less money enables a manager to get in and out of positions more quickly says Ken Gregory in the current issue of his No-Load Fund Analyst newsletter. Small funds can take meaningful advantage of investments that would have little discernible impact on the performance of a big fund. Sometimes, Gregory says, size may offer advantages as well. A big fund may be able to exert more clout in the markets, and to pay the costs of better research.
Is the fund industry's treasured reputation for trust and integrity vulnerable to lasting harm should misdeeds be proved? There is certainly that risk. That brings into sharp focus one of the most puzzling aspects of this case. Fund managers are supposed to be skilled at gauging the pluses and minuses of any situation. In the circumstances described in Spitzer's complaint, the alleged reward was a chance to curry favor with a hedge-fund client or two. Put that up against the $6.9 trillion in total assets the fund industry has riding on its reputation. It's certainly not the sort of risk-reward calculation I'd want to see from anybody I trusted with my money. Reopening Glass-Steagall Issues Fund Action 9-11 New York Attorney General Eliot Spitzer's allegations that mutual funds made illegal trading agreements with a hedge fund raise issues about corporate ownership of mutual funds. One quid pro quo under review raises particular conflict of interest issues, said Burt Greenwald, a mutual fund consultant based in Philadelphia. The Spitzer complaint notes that Bank of America's private bank, part of its asset management division, provided a loan commitment for Canary Capital Partners' trading strategies, including the alleged illegal after-hours trading. Greenwald said, "BofA was seeking a full relationship with Canary, almost as a prime broker. These would not be issues with a standalone fund company" that did not have other services to peddle. "This could reopen a lot of the Glass-Steagall issues, separating banks and investment managers."
McDonald: Seems like Mr. Spitzer is pursuing individuals and the SEC is questioning companies. Why the split and how long will this probe take? Barbash: There is a key difference. Mr. Spitzer's review is more focused on people and their conduct, while the SEC is looking at firms and their processes. I think that makes sense because the state officials are looking at the behavior of people, mostly those located or doing business in New York, while the SEC is looking more broadly for companies and procedures that violated securities laws. That's not a bad way to split up the work. The SEC is also trying to do some fact finding on the nature of intermediaries and how funds are sold. The staff has had a lot of other things to do, but now we see that in this down period for funds, some pushed the envelope. So, they're trying to learn as much as they can by studying the nature of distribution agreements and processes at the 80-largest fund companies. As a practical matter it's hard to say how long this will take. Some fund groups have 500 to 600 distribution agreements. It will take a heck of a lot of time to go through them. I think there will be a press on the staff to have some findings by the end of the year. But somebody did joke that Eliot Spitzer will be governor of New York before the SEC staff is through with this paperwork.
The study used TrimTabs Investment Research, which provides estimates of flows into and out of mutual funds. Prof. Zitzewitz said that by agreement with Trim Tabs, he couldn't name individual funds or fund companies. He said it was possible fund companies weren't aware of the trading because many have agreements with brokers and other intermediaries, which collect what are supposed to be pre-4 p.m. trades but provide them to companies later in the day. About 14% of the industry participates in TrimTabs's daily reports estimating flows into and out of mutual funds. From Thor Valdmanis, USA TODAY 9-12: The practice of "late trading" is so rife that individual shareholders lose about a nickel for every $100 invested in international funds, and over half a penny in domestic funds, according to the findings. Zitzewitz said "Before I read about Spitzer's investigation a week ago, I never thought to look at late trading," he said Thursday. "It never occurred to me before because the practice is just so obviously illegal."
It is easy to understand how this may be so. The large cash flows that result from market timers' frequent trading can lead to significant transaction costs, which are borne equally by all shareholders, not just by the traders themselves. This is why almost all funds include language in their prospectuses reserving the right to reject share purchases from investors deemed to be market timers. In practice, few funds actually prohibit someone from investing in them, though many impose fees that discourage short-term trading. According to William N. Goetzmann, a finance professor at Yale, dealing with the inflows and redemptions induced by market timers is little more than a "minor cash-management problem" for most fund managers. Professor Goetzmann points to the performance of index funds. Even though they are used heavily by market timers, their returns are typically close to those of the market averages that are their benchmarks. He contends that this would not be the case if market timers were causing a significant diminution in fund returns. But market timing does have adverse consequences for long-term shareholders of foreign stock funds. Consider a fund based in the United States that invests in Japanese stocks. Because Japan's stock market will have been closed for hours when this fund calculates the value of its net assets at 4 p.m. in New York, its share price will not reflect any news from the last several hours. Market timers can use this stale pricing to make an easy profit without having to get help from a mutual fund to trade after the market close in New York. Traders can buy foreign funds immediately before the close on any day the stock market in the United States has risen strongly, and sell whenever the market has sharply declined. This strategy exploits the tendency of foreign stock markets to follow the lead of the market in the United States. Two finance professors, Jason T. Greene of Georgia State University and Charles W. Hodges of the State University of West Georgia, analyzed the price that longer-term investors in foreign funds had paid for market timers' pursuit of such strategies. Armed with a database of fund inflows and outflows from 1993 to 1998, the professors calculated that market timers in foreign funds had earned an average of more than $1 billion a year at the expense of long-term investors. For the average long-term investor in foreign stock funds, that meant a reduction in annual returns of about 0.5%. If you are a long-term investor in foreign stock funds, your best defense against market timers is to invest in a fund that discourages short-term trades. Funds that rely on redemption fees are preferable to those that use back-end loads. Back-end loads are paid to the fund's sales representatives, while a redemption fee is typically paid back into the fund itself to reimburse shareholders for the costs of the trade. "The dilution impact of daily fund flows on open-end mutual funds" Jason Greene and Charles Hodges A large body of literature documents the interaction between the U.S. market and international markets. These studies generally show a contagion effect, in which price movements in one market spill over into other markets. The strongest correlation appears to originate in U.S. market moves. For example, a late-afternoon (New York time) increase in the U.S. market creates expected increases in the Asian and European markets which are closed at the time of the U.S. move. [The data on 84 'World Stock' or Foreign Stock' funds gathered by Greene and Hodges had a] 13.3% average annual return to a buy-and-hold investor (ignoring distributions) across these international open-end mutual funds from 1993 through 1997, compared with the S&P 500's 18.4% return. For each fund, we calculate the return to a market timer using the daily timing strategy based on the S&P 500 signal. This averages slightly over 34% per year across the international funds. These results are consistent with the expected returns in Chalmers, Edelen, and Kadlec (2001), Goetzmann, Ivkovich, and Rouwenhorst (2001), and Bhargava and Dubofsky (1999). We also calculate the success rate by determining the percentage of days that the market timer is correct (i.e., invested in the fund on up days and in cash on down days). Across these funds, the average success rate is 63%. A buy-and-hold investor in the market index has a success rate of about 52%, as this investor is correct on all 'up' days and incorrect on all 'down' days. We show that daily fund flows in international funds appear able to predict subsequent-day returns, while flows in domestic funds are unrelated to the following day's returns. Greene and Hodges concluded that market timing diluted the returns of the nontrading, or passive, shareholders. For international mutual funds exhibiting the highest level of fund flows, we estimate a -0.94% average annualized dilution impact on returns and a reduction in annual returns of about 0.5% for average funds.. We find little evidence of daily fund flows consistent with profitable trading in domestic funds and find no significant average dilution impact. There are other studies that suggest a higher dilution than the one found by Greene and Hodges, and two of them are listed below. And I can off the top of my head think of two reasons that the dilution could be greater in the present than in the 1993-1997 world that was the source of the Greene and Hodges findings. (1) An increased amount of volatility in the markets. And (2) an increased amount of money invested in hedge funds. It is logical to me to suspect that the larger the percentage of dollars invested in hedge funds, the more damage they could do with their timing in mutual funds. A possible third reason: A strategy that could generate a 35-70% return will attract money and abuse. A fourth reason: Greene & Hodges used the S&P 500 as a measure - and there are many more indexes popular now that could correlate to specific markets - especially foreign markets. I would guess that the Nasdaq correlates more strongly to some tech heavy Asian markets than the S&P - and they would be even more volatile. A BW Online article of 12-11-02 by Amey Stone quoted Zitzewitz saying he found that from 1998 to 2001, investors could have earned a potential annual return of 35% to 70% using the market timing strategy in international funds, about twice as much as they could have made from 1992 to 1996. Zitzewitz' research found that the resulting shareholder dilution has risen from 0.50% in 1999 to 1.14% in 2001. The 1.14% is an average - and dilution is higher in some volatile funds. Add the costs of executing the trades, and a fund that would have gained a hypothetical 10% would return only 8.15% - thanks to the traders. Fund investors are already losing up to $5 billion a year to arbitrageurs, Zitzewitz estimates. Greene's 1999 estimate was a total of $1 billion lost. This scandal could grow much larger in a hurry. And it could scare off people from investing at a time when equity investing could be the best for them. So do not just skim though these academic studies. It is tough and dry reading - but now is a time when you need to be most informed. "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds" Eric Zitzewitz, Stanford Graduate School of Business October 2002 Arbitrageurs who buy international funds on days the S&P 500 has risen and sell them on days it has declined can earn uncompounded excess returns of 35% per year; refinements to the trading strategy can double these returns. The arbitrage returns available in domestic small-cap and convertible and high-yield and convertible bond funds are smaller but still substantial, at 20-25% and 10-25%, respectively. Dilution is concentrated in international equity funds, where the arbitrage opportunities are largest; in 2001 it averaged 1.1 and 2.3% of assets per year in general and regionally-focused international funds, respectively. Dilution of long-term shareholders has grown rapidly in the last four years, and the mutual fund industry is beginning to respond. But given the size of the problem, the industry response has been surprisingly slow. Fund Flow Volatility and Performance David Rakowski [Grad Student] Georgia State University April 2002 Rakowski found a significant and robust negative relationship between the volatility of daily fund flows and cross-sectional differences in performance. The interaction of turnover, fund flows, and performance documented here is consistent with fund mangers trading excessively not because they are attempting to 'churn' the portfolio, but because they must trade in order to manage investors' liquidity demands. Chalmers, Edelen, and Kadlec (2000) find that trading costs are negatively related to performance and have more explanatory power than turnover. Grinblatt, Mark, and Sheridan Titman, 1989, "Mutual Fund Performance: an Analysis of Quarterly Portfolio Holdings" (1989) find that over half of a fund's transaction costs and expenses arise from discretionary and liquidity-motivated trading. Similarly, Russ Wermers ("Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses" 2000) discovers that mutual funds hold stocks that outperform the market by about 1.3% per year, but that their net returns under-perform by about 1% due to the underperformance of non-stock holdings, expenses, and transaction costs. Chordia (1996), Berk, Jonathan, and Richard Green, "Mutual Fund Flows and Performance in Rational Markets" (2002), and Nanda, Vikram, I.P. Narayanan and Vincent Warther, "Liquidity, Investment Ability, and Mutual Fund Structure" (2000) all develop models where liquidity needs (flow) play a role in determining fund structure (fees and performance). The empirical implications of these models are that loads and fees will be negatively related to flow volatility, and positively related to performance. Summaries below are by Greene and Hodges and are from their study mentioned above. Chalmers, J., Edelen, R., Kadlec, G., 2001. "On the perils of security pricing by financial intermediaries: The wildcard option in transacting mutual-fund shares." - They argue that a 'wildcard option' exists in a broad cross-section of domestic and international open-end mutual funds as a result of stale prices. These stale prices give rise to profitable trading strategies in which active traders can earn abnormal returns of 10% to 20% annually. Bhargava, R., Bose, A., Dubofsky, D., 1998. "Exploiting international stock market correlations with open-end international mutual funds." and Goetzmann, W., Ivkovich, Z., Rouwenhorst, K., 2001. "Day trading international mutual funds: evidence and policy solutions." show that successful trading or market timing is possible in three international mutual funds. We confirm this finding and show that abnormal returns result from a market timing strategy in a large sample of international mutual funds. Edelen, R., Warner, J., 2001. "The high-frequency relation between aggregate mutual fund flows and market returns." focuses on how some of the indirect costs from this liquidity role can affect the performance of mutual funds and the inferences made in studies of managersĖ selection and timing skills. Using monthly fund flows and semi-annual fund transactions data, his analysis shows that liquidity-motivated flows can have an economically significant impact on the return to the mutual fundĖs passive investors through increased expenses and trading costs. Goetzmann, W., Massa, M., 1999. "Index funds and stock market growth." and Edelen and Warner (2001) find that daily fund flows into and out of domestic mutual funds are correlated with, and could even cause, movements in the underlying U.S. markets. These two studies suggest that the flows of money into and out of mutual funds can have a measurable impact on the overall market. Stale prices on not just a problem in international funds. There is even some stale price amoung U.S. shares while the markets are open. The description of the example/study below comes from William Goetzmann & Zoran Ivkoviv in "Day Trading International Mutual Funds: Evidence and Policy Solutions" 2000. The Russell 2000 index tracks a portfolio of small stocks in the U.S., many of which are traded infrequently. Because the value of the index is calculated using the most recently available transaction prices, many of which are stale, the return on a portfolio of larger and more frequently traded stocks, such as the S&P 500, tends to lead the return on the Russell 2000 (A.W. Lo, and A.C. MacKinlay. "Stock Market Prices Do Not Follow Random Walks: Evidence from a Simple Specification Test." 1988).
Gerald Malone, a veteran technology-stock investor who runs the $3.2 billion AllianceBernstein Technology Fund as well as two Alliance hedge funds, and Charles Schaffran, a marketing executive who sold Alliance hedge funds to investors, were suspended. The moves were based on the preliminary results of an internal inquiry, which found that certain investors were allowed to make rapid trades in a mutual fund managed by Mr. Malone in exchange for making large investments in Alliance hedge funds also run by Mr. Malone. The Alliance moves underscore potential conflicts long raised by critics of a trend in the mutual-fund industry for mutual-fund managers to also oversee hedge-fund portfolios. In recent years the list of asset managers running both mutual funds and hedge funds has grown longer, including J.P. Morgan Chase & Co., Invesco Funds and Citigroup, in addition to Alliance. Concerns about the dual roles have focused on trading conflicts. A firm managing both hedge funds and mutual funds might direct its best ideas or coveted IPO shares to a hedge fund to earn higher performance-based fees typically paid by hedge funds but not by mutual funds, for example.
Janus Chief Executive Mark Whiston said the company had ended the relationships and sought to downplay the impact on its mutual funds, noting that only "four of these [relationships] actually engaged in frequent trading." Mr. Whiston said the assets traded, at their peak, accounted for 0.25% of Janus's total assets under management of $152 billion. But the mutual funds mentioned as having been traded have only $27.6 billion in assets, according to the company, suggesting timers at one point represented a more significant share of the assets there.
Steven Markovitz, one of the hedge fund's most successful traders in recent years, acknowledged that between late 2001 and July 2003, he placed orders on behalf of Millennium to buy and sell shares of mutual funds after the 4 p.m. Eastern time stock-market close but at 4 p.m. prices. Mr. Markovitz faces as many as four years in prison when he is sentenced later this year for violating New York's Martin Act, which prohibits investor fraud. Now, people close to the probe say they are receiving information at a rapid clip from individuals in the industry suggesting that such post-4 p.m. trading was much more widespread than they anticipated. More charges will be brought against other hedge funds, mutual funds and brokers, the people close to the probe say. Damage to Janus and Strong Fund Flows The mutual-fund trading probe launched early last month may be hurting new business for some companies included in the investigation. Stock funds managed by Janus Capital Group Inc. had net withdrawals of $2.4 billion in September, according to data from AMG Data Services. Strong Capital Management stock funds had net withdrawals in September of $69 million, according to a Strong spokeswoman. Bank of America Corp. and Bank One Corp. attracted new money to their stock funds during the month, according to AMG.
Putnam has said it has done nothing wrong and sought to stop the rapid exchanges. For the union members, such trading is legal, and state regulators aren't expected to accuse them of any wrongdoing. Putnam, a unit of insurance broker Marsh & McLennan, also said its own internal investigation of five years of trading in its 401(k) business had turned up fewer than 100 market timers out of 1.9 million plan participants.
Morgan Stanley, a big Wall Street brokerage firm, said in a routine filing with government regulators last week that the SEC was considering bringing charges against it, partly on the ground that it allegedly favored certain fund companies based on brokerage commissions "received or expected" from them. In the latest investigation, the SEC is looking at whether investors were misled by brokers who sold them funds because of lucrative arrangements their firms had with mutual-fund companies. The inquiry also is looking at whether mutual-fund companies overpaid in commissions in return for brokerage firms agreeing to promote their funds. Early this year, Morgan Stanley established a "partners" list of 14 fund companies that, in addition to in-house funds, would be favored by the firm's brokers when recommending investments to clients, according to Morgan Stanley. Morgan brokers can earn higher commissions when they sell funds from companies on the partners list than if they sell nonpreferred funds. Brokerage firms such as Morgan Stanley almost always have business arrangements that can affect which funds end up on their recommended lists. These arrangements often involve mutual-fund companies making payments to brokerage houses, ostensibly to help defray the out-of-pocket costs that brokers incur when marketing mutual funds. These deals, known as "revenue sharing" agreements, are widespread and help fund companies induce brokers to market their brand of funds out of the thousands of investment options that are available to clients. Such revenue-sharing agreements, by themselves, don't necessarily violate any rules. Funds, like other large investors, are also allowed to direct trading commissions as a form of compensation to brokerage firms for providing research, in a practice known as "soft-dollar" arrangements. But fund-sales arrangements that are contingent on trading commissions are a different story, fund-industry observers say. "If a fund adviser receives a benefit in the form of research that can benefit an investor, that's OK. But there's a clear distinction between that and generating sales from which the adviser will get more fees and the shareholders do not get any benefit," says Tamar Frankel, a Boston University law professor who specializes in mutual funds. More on Putnam Chuck Jaffe, CBS MarketWatch 10-23 Massachusetts Secretary of the Commonwealth William F. Galvin is preparing to file a civil complaint against Putnam. In Putnam's case it appears regulators will maintain that Putnam made timing a selling point in luring a few big retirement plan sponsors. In Putnam's case it appears regulators will maintain that Putnam made timing a selling point in luring a few big retirement plan sponsors. The biggest threat to the funds at the firms impacted by scandal is that investors flee. No one is forecasting a run on the funds; while money has been pulled from the firms already tainted, it hasn't been a strategy-changing flood. In theory, a fund that sees significant redemptions would sell stocks across its portfolio to meet the bailout. By dumping positions in its stocks, the fund drives those prices down and the remaining investors can get hurt. And for investors who haven't been drawn into the scandal yet, don't believe you are out of the woods. "This is going to be a long, drawn-out affair and we're just at the beginning of it," says Eric Kobren, who runs Kobren Insight Management [which has mutual funds that invest in other funds]. "Six months from now, we'll be talking about the same issues, but we'll be putting the names of new fund companies in there."
Most funds say they discourage these quick in-and-out trades by imposing high fees, but the survey found that some companies cut special deals with wealthy investors that may have violated disclosure rules. Preliminary data also suggest that employees at 10% of the fund companies knew some customers were violating the rules against "late trading." And even fund companies that did not allow market timing may have been victimized because almost 30% of the brokers helped clients circumvent company rules against the practice. The SEC launched its comprehensive survey in September and found that late trading was surprisingly common. A 1968 law requires fund customers who place orders after 4 p.m. to get the next day's price, but the SEC found that seven large brokerage houses out of 34 had allowed customers to place or cancel orders after that deadline, allowing them to illegally exploit news announced after the New York stock markets closed. The NASD, an industry regulatory group, is surveying smaller brokers to see if similar problems occurred in their sector, and its enforcers have already opened 30 cases connected to either late trading or market timing, sources said. In the SEC survey, about 70% of the brokers said they were aware that some of their customers were timing the market and 30% said their employees had helped clients carry out that task. The SEC also found that one-third of fund companies shared detailed information about their fund portfolios with favored customers. That selective disclosure may be illegal and certainly made it easier to engage in market timing and other improper trading.
The mutual funds being traded through the Prudential brokers generally weren't those run by Prudential itself, but those offered by other fund groups including Putnam Investments and Hartford Mutual Funds. Suspecting that the Prudential group was helping clients with market-timing, some of these funds repeatedly tried to cut off the Prudential brokers. But the brokers continued to operate, the preliminary complaint states, by hiding their identities through a variety of subterfuges. They entered false ID numbers, used different branch identifier prefixes including those of North Miami and the West Indies, and used "unknown" as an identifier "to obscure their identity." They also used other tricks to avoid detection, including executing trades under certain threshold amounts, such as $100,000 or $250,000, the complaint says. In many cases, the complaint says, the brokers were assisted by friendly mutual-fund wholesalers, who would tell them the threshold levels or advise which funds weren't being closely monitored. More Recent Events Bill Deener, Dallas Morning News 11-04 Monday the National Association of Securities Dealers ordered almost 450 brokerage firms to notify investors that they may be eligible for partial refunds on commissions paid to buy mutual fund shares. The firms, which the NASD didn't identify, are accused of inadvertently not giving large investors discounts to which they were entitled. Such discounts totaled at least $86 million in 2001 and 2002, the NASD and SEC said in a statement.
Donald Christensen, a veteran of Wall Street, saw problems looming in mutual funds long ago. In his book, "Surviving the Coming Mutual Fund Crisis," published in 1994, he recounted the history of scandals involving mutual funds and predicted that a new one would unfold by 2000. He was early and not prescient enough to foresee that fund managers would be accused of trading in their own fund shares at the expense of their shareholders. But he did recognize the risks that inevitably arise when investors throw money indiscriminately at a financial concept. Rather than being surprised by the way the scandal was unfolding, Mr. Christensen said it was mirroring what had happened during previous periods of fund abuses, in both the 1920's and the late 1960's. The industry should not take solace in the fact that many investors are holding onto fund shares in the face of the disturbing allegations by regulators, Mr. Christensen said. In past fund crises, he said, investors have taken quite a while to dump their shares. "In the 1970's, the peak of the withdrawals was not during the scandals, but in the aftermath of the scandals," he said. Back then, fund managers got into trouble by buying illiquid or highly risky securities. Redemptions hit and investors suffered huge losses. And as Mr. Christensen pointed out in his book, it takes only a few misbehaving mutual fund managers to make investors wary of an entire industry.
Wasatch is a terrific fund company - I own one of the firm's funds myself - which has closed most of its funds to new and existing investors in an effort to keep assets at an optimal size. Closing funds protects shareholders, but also creates issues; and fund firms resolve issues by changing rules. In Wasatch's new statement of additional information, which will be incorporated into the prospectus in a few months, the firm writes rules covering funds that are "closed to new investors," or "closed to new and existing investors." There are rules, and then there are exceptions. For example, the codicils allow Wasatch to make closed funds available to "Premier Services clients" as well as certain employee-benefit plans or through firms that act as intermediaries and sell the funds to their customers. What's more, management can allow the exceptions so long as they do not "adversely affect shareholders," words that actually raise the hurdle regulators must clear before bringing legal action. In fact, regulatory officials close to the Massachusetts case against Putnam say that if the troubled fund giant had used similar language to make exceptions clear, there's a good chance there would be no civil charges for the special deals certain investors allegedly enjoyed in a select few retirement plans. As one securities lawyer said after seeing Wasatch's changes: "If I'm their lawyer, this is good lawyering." Eric Johnson, director of mutual funds at Wasatch, said the changes were made mostly to clarify rules - putting answers to its most frequently asked shareholder questions into code - and to accommodate special situations, like the grandmother who wants to make an annual deposit in a gift account but who couldn't under the old rules. But he acknowledged that the scandals made the fund company want to be crystal clear about what it could allow. Johnson said, "In this business, there are more exceptions than there are rules, and we do want to give ourselves some leeway to make decisions as needed." But if the scandals show anything, it's that funds given an inch can take a mile. So long as the fund firms are writing their own rules, the problems will not be fixed.
The first question - about management never investing the money it gets and the whole thing being a paper sham -- highlights how little many investors know about how their funds actually work. Virtually all money in mutual funds today -- whether cash, shares of stock or any other security -- is held by an independent custodian. While some fund managers and company executives seem to have lost sight of their responsibilities, they were not pulling cash out of the fund to do it. Moreover, none of the charges filed, or even in the hopper for what's likely to be next, involve fund executives absconding with the stock certificates and heading for Switzerland. The second question - investors who hold funds in an individual retirement account, or IRA, can move it without facing any tax consequences. There may, however, be transfer fees, deferred sales charges -- if you own a fund's B share class -- and potentially new sales charges if a financial adviser is involved in making the switch. Investors who own the funds in a taxable account face those potential charges plus any capital gains they might realize upon dumping the funds. The third question - pressure your employer to make a change in the plan. Plan administrators don't want to stick around in the offending funds any more than you do. If workers press for diversifying the retirement plan offerings, they may be able to get somewhere.
This time, the SEC's action is different from the normal settlement, however, in that the agency rushed it, needlessly. Why settle now? The investigation is barely weeks old and apparently is still continuing. It seems implausible that the regulators possibly could have found most of the violations -- or even a significant portion of them.
"I believe this is the worst scandal we've seen in 50 years, and I can't say I saw it coming," said Arthur Levitt, the former chairman of the Securities and Exchange Commission for nearly eight years under the Clinton administration. "I probably worried about funds less than insider trading, accounting issues and fair disclosure to investors" by public companies. One of the clearest examples of the industry's clout can be seen in the Sarbanes-Oxley Act of 2002, the landmark legislation that was Congress's response to the wave of corporate scandals that included Enron and WorldCom. The broad corporate governance reforms and antifraud provisions of the act have been felt in boardrooms across the nation. But at the urging of the industry's trade organization, the Investment Company Institute, the drafters granted the mutual fund industry significant exemptions from some of the more important provisions. Those provisions enacted stringent conflict-of-interest rules, required greater disclosure of transactions between management and large shareholders, and imposed tougher requirements on management to monitor internal controls.
There's something soothing in this view, as it implies that corruption isn't such a problem during normal times. But that's false reassurance. Greed is always with us. It's only the opportunity to make it pay that waxes and wanes. The reason we see more corruption after bubbles pop is that a collapsing market often causes a financial house of cards to tumble, exposing frauds such as Enron. Then we start looking harder for other cases. Last week, the House adopted a set of watered down measures to deal with market timing, the fast in-and-out mutual-fund trades that make money for speculators but undercut returns for a fund's ordinary long-term investors. The centerpiece is a rule change that would allow funds to charge more than the current 2% maximum as a penalty for investors who make short-term trades. But the measure would not require fund companies to impose this fee. Indeed, many of the companies now embroiled in scandal had such fees in their rules at the time, but they waived them for favored clients. The House measure would allow Washington to claim it had passed reforms, while leaving investors at the industry's mercy. Greed is a permanent, everyday feature of the financial-services industry. There's not much chance regulators and politicians will do more than paper it over. Of course, if you yell at your legislators, it might help. To be heard over the big-business lobbyists, you'll have to be awfully loud.
"The late-trading issue is small potatoes compared to something like revenue sharing," says John Montgomery, president of Houston-based Bridgeway Capital Management, one of the few fund executives to publicly oppose this type of back scratching. "This is a very big issue with widespread implications for how funds will trade in the future." Bridgeway's Montgomery complains that while four of his funds have been among the top 15 performers in their categories over five years, his fund group has attracted only $1.3 billion in assets, much less than weaker performers that use revenue sharing to get brokers to sell their funds. "These days, performance alone is not enough to attract a critical mass of assets," says Montgomery. For years, the SEC has held that fund brokerage activities should always be done in the interest of fund shareholders, not fund firms. The defining decision came in the SEC's 1967 suit against Delaware Capital Management for directing its brokerage business in return for mutual-fund sales. "By allocating trading flow to brokers who sold the most shares of their fund, [Delaware] violated its own responsibility to the funds to secure the best execution," the SEC said. A special exemption for "soft-dollar" payments - those in which research or other services are exchanged for promoting a fund - came later, and only after intense lobbying. During the summer, Paul Roye, chief of the investment-management division of the SEC, sent a 121-page brief to Republican Rep. Richard Baker of Louisiana [an author of a mutual-fund reform bill], arguing that the primary legal issue raised by revenue sharing "is whether the payments are an indirect use of the fund's assets to finance the distribution of its shares." Roye told Baker that SEC examinations of funds and brokers showed that, to boost sales, funds' investment advisers typically offered brokers as much as 0.25% of annual gross sales and an extra 0.05% of the net assets held by a broker's customers. Funds that made the special payments went on Morgan Stanley's "preferred list." Brokers were told to refer to this list first when recommending mutual funds to their customers. The gist of the issue as I understand it: Mutual funds use brokers [just like you and I] to buy shares of the stock they own. We would like them to consistently use a discount broker. But if a "full price" broker sells shares of the mutual fund, then the fund company would compensate the brokerage by using the "full price" brokerage to buy the shares it has in its funds - thus causing extra expense to its current share holders. This has been legal up to now under the assumption that the brokerages were sharing research with the fund companies - so the extra compensation could be ethically given. - But it appears the Morgan Stanley ordeal was a bit more complex than even that - as Chuck Jaffe writes in the article below.
By comparison, A shares carry the traditional front-end sales charge, meaning that the investor pays several points off the top to compensate the broker. The key issue here is that A shares have "breakpoints," where an investor who plugs in a lot of money -- at least $50,000 -- can get a discount on the sales charge. The more breakpoints investors qualify for, the less they pay in sales charges and the better the deal they get on the fund by purchasing A shares. There are no breakpoints in B shares. So by not telling the investors that they might save money in A shares, Morgan's staffers were pulling money directly out of the pockets of the shareholders. Quick Facts, Stats & Opinions Bear Stearns Fires Four Bear Stearns, a big financial company that processes trades for dozens of other brokerage firms, quietly fired four brokers and two assistants last week in an action related to mutual-fund trading activity. Bear processes about 8% of the trading volume on the New York Stock Exchange through its National Securities Clearing Corp. unit. In a seperate lawsuit, it is charged that Bear provided an electronic routing system for mutual-fund purchases to other securities firms and fund timers. These included Canary and Millennium Partners. The suit, which is seeking class-action status, alleged that Bear created the electronic routing system "without any requirement or safeguard" to ensure that orders received after 4 p.m. were given the next day's mutual fund price, as required. Within the last month, the lawsuit noted, Bear modified its electronic fund trading system to enforce a 4 p.m. cut-off time. Bear also allowed fund timers to cancel their orders after 4 p.m. if "material news events" occurred. And Bear allowed clients to use "multiple accounts or 'cloning' to directly assist and hide" the activities of fund timers, the lawsuit said. (Randall Smith, WSJ 11-17) Violations Found at Schwab Charles Schwab, which popularized mutual-fund investment through a pioneering "supermarket" of funds, disclosed it had found a "limited number of instances" of questionable trading as well as other issues at its U.S. Trust Co. unit. Two employees of Schwab in the institutional mutual fund sales group at its U.S. Trust unit have been terminated for allegedly attempting to destroy documents related to the regulatory inquiries, a U.S. Trust spokeswoman said. (Randall Smith, WSJ 11-17) Probe Could Mean Cash for Large Fund Investors For investors who see the mutual-funds probe as a daunting web of suspects and a confusing array of offenses, here is a reason to pay heed: compensation. Morgan Stanley, Legg Mason Raymond James, and American Express Co. are a few of the investment companies under orders to put a price tag on damages and pay up. (Todd Mason, Philadelphia Inquirer 9-18) New Focus on Fees The coming battle over mutual fund regulation may well end up focusing not on trading abuses, which are now the subject of regulatory action, but on the fees and costs that funds charge investors. (Floyd Norris, NY Times 11-19) Home Page Previous Factoid Too Top Sites
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