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Industry executives said that companies had been providing information on variable annuity investments to regulators for several months but that they were unaware of improper trading practices. "We don't know of any violations or to what extent violations have been found among our members," said Michael DeGeorge, general counsel of the National Association for Variable Annuities. "To date, there's been no finding of widespread abuse within the variable annuity industry."
By contrast, the expense ratio for investors in the Morgan Stanley S&P 500 Index fund can be as high as 1.5%, while the Scudder S&P 500 Stock fund charges as much as 1.8%, according to Morningstar. (Costs vary within these funds depending, for example, on whether investors pay an up-front broker's commission.) The average fee for a large, S&P 500-style index fund is 0.73%, according to Morningstar data. Higher fees can significantly reduce an investor's profits. For example, a $10,000 investment in the Vanguard 500 fund seven years ago would be worth $16,604 today. The same investment in certain shares of the BlackRock Index Equity fund, which has a 1.53% expense ratio, would total only $14,967, according to Morningstar. The legal issue in the SEC probe hinges on whether high index fund fees are reasonable. Under the Investment Company Act of 1940, fund directors have a fiduciary duty to shareholders, meaning that among other things, they must make sure management fees aren't excessive. Some companies that sell their funds through brokerages defend themselves by saying their fees cover the advice investors receive from brokers. But critics say it takes little effort or know-how for brokers to stick clients in index funds. Attorney Bob Friese, who represents fund companies and other financial services firms, called Vanguard Group's fees "extraordinarily low - even by pension fund standards." With hundreds of billions of dollars under management, indexing pioneer Vanguard has economies of scale that others don't. Its costs are spread out over a much larger base of shareholders than almost all other index funds.
Only 13% of fund purchases last year were made by investors directly contacting fund companies. Most funds are sold through third parties such as brokers, independent advisors and 401(k) retirement plans. According to a 2003 poll of 34 fund companies by consulting firm Greenwich Associates, the mutual fund firms paid $2.6 billion in commissions in 2002 to buy U.S. stocks. About 6%, or more than $150 million, of the commissions were directed brokerage payments. The funds' average commission was 4.2 cents, double the amount for electronic trades. John Hill, chairman of the Putnam's board of trustees, said "The six portfolio managers who were market timing Putnam funds got a total of $600,000 to $700,000," Hill said. "Directed brokerage costs $30 million to $40 million a year at Putnam. And it's year in and year out." December Scandal Update
Commission officials said they asked a federal judge in Las Vegas to freeze Calugar's assets and the assets of his company after learning he withdrew $50 million from his MFS accounts on the same day the SEC publicly identified him as a large user of market timing in a settlement with Alliance. The commission alleged that Calugar improperly profited from moving more than $400 million in and out of Alliance and MFS funds. "Calugar's market timing and late trading were phenomenally profitable to him and came at the expense of long-term mutual fund shareholders," SEC regional director Randall R. Lee said in a prepared statement. "By obtaining a court order freezing Calugar's assets, the Commission has taken action to preserve funds to be returned to the victims of his illegal schemes."
But federal regulators' quieter fee moves - if enacted - would make a bigger and more lasting difference for small investors. The SEC is drafting provisions, which would apply industrywide, to make funds' fees and their drag on returns far clearer and more important to fund directors and the public. This plan will have a bigger impact on keeping fees reasonable for Main Street investors over the long-term. Here are three reasons why: Sunshine's Effect on Fund Directors The current furor over fees is giving boards the attention they've long deserved - most of it negative. In recent months, Mr. Spitzer, Warren Buffett, Vanguard founder John C. Bogle and a host of lawmakers have sharply criticized fund boards for being lax in representing shareholder interests. But over the next two months the SEC will mull proposals that would raise the number of independent directors on each fund board and force these folks to explain in shareholder reports a fund's fees and why they think they're reasonable. In an interview posted to the Online Journal last week, former SEC Chairman Arthur Levitt said fund boards will be tougher "due to embarrassment." Sunshine's Effect on Fund Investors Next month the SEC plans to finalize rules that would require funds to disclose fees in dollar terms, in addition to listing the expense ratio. Regulators are also looking for a way to disclose each fund's transaction costs, which are currently reflected in a fund's net asset value and aren't disclosed in the expense ratio. There has been talk of putting this information on shareholder statements. While a long shot, some believe this change might give the disclosure more oomph. "Call up investors at random and they'll admit they don't know what their funds' fees are," says Stephen Cecchetti, a finance professor at Brandeis University. "But surveys show they read their quarterly statements, if not prospectuses and shareholder reports. More people will notice fees if funds tell you what they charged each quarter." One caveat to this seeming benefit: Adding personalized fees to account statements would be costly for funds, brokerages, and perhaps, in turn, investors. The proposed disclosures will make a fund's fees clearer and easier to compare. If funds' transaction costs are included in their expense ratios, funds' price tags will be steeper and harder to ignore. Investors and financial advisers may be paying more attention to funds' tolls already. So far this year, same as in 2002, the nation's top-selling fund firms by far are American Funds and Vanguard. These firms funds sport annual expenses far below industry averages. Systematic Changes Trump Sporadic, Short-Term Punishment If the lesson of the current fund-trading scandal is that problems with integrity and fund governance are systemic in the fund world, then these problems need a systemic solution. That's where Mr. Spitzer's fee-cut at Alliance falls short.
Some pension plans and consulting firms that build portfolios for institutional investors are reviewing their relationships with companies accused of trading abuses by American authorities. Unilever, the British and Dutch maker of food and household goods, has gone a step further and has fired Putnam Investments as a manager of its British pension fund, in response to abuses in Putnam funds in the United States. Many companies under investigation in the United States have big operations internationally. Companies that are found to have broken trading rules, either in funds sold in the United States or abroad, are bound to lose business from large foreign investors like pension funds, and from financial advisers who steer small investors into funds, European advisers and consultants said.
Using that measure, the ICI found that timing probably took place in 566 of the 899 international funds, but that those funds only had 38% of the $412 billion invested in international funds. Similarly, 93 of the 197 high-yield bond funds - generally junk bonds mixed with investment grade bonds - had high turnover, but they held only 16% of the $136 billion invested in that class of funds.
1. A Bulletproof Business Model A fund company typically pockets a set percentage of fund assets for investment management or customer service, whether fund shareholders are making money or not. Given that many investors have bought into the "buy and hold" mantra and pay more attention to returns than fees, most firms' revenues tend to be both stable and healthy, even in bear markets. The average publicly traded fund firm sports operating margins of 35%, compared with about 6% for the average company in the S&P 500, according to Morningstar. During the bear market, many firms kept their revenues up amid shrinking assets by cutting staff and raising fees. Janus Capital Group Inc. has more than halved its headcount since it peaked at nearly 3,000 employees in 2000, for example. And from 1999 through 2001, fees charged by the nation's largest stock funds rose 11%, according to a study by Congress's GAO. Even fund firms mired in today's scandal and facing outflows have seen their assets (and profits) buoyed by the market's rising tide this year. At the end of October, Alliance Capital Holding LP, which said it found evidence of improper trading of its funds at the start of that month, reported a 19% jump in assets and a 26% rise in quarterly income from a year earlier. 2. A Vast, Captive Audience The hum-drum 401(k) investor, dutifully plunking a sliver of each paycheck into a retirement fund account, drives the fund industry's success. The majority of fund shares are held in tax-deferred accounts, with $2 trillion invested in defined-contribution retirement plans such as 401(k)s. In many of these accounts, investors are essentially a captive audience usually choosing from a short menu of funds. Since these accounts are designed for big-ticket, long-run goals, money tends to keep coming into them - boosting fund revenues - whether markets are soaring or slumping. Inflows to these accounts comprised about 85% of funds' overall intake last year, according to data from the ICI. 3. One Firm's Loss is Another's Gain Since the scandal broke in early September, implicated firms have been pilloried by redemptions. But that money has largely gone to other fund firms and not the bank. 4. Where Else Are You Going to Go? Even irate investors who want out of funds altogether might, in the end, find it doesn't make sense to leave. Hedge funds or separately managed accounts carry high investment minimums. Exchange-traded and closed-end funds require investors to pay commissions each time they buy shares. And if you chose funds because you lacked the time or expertise to pick stocks or bonds, disgust with abusive practices at several fund firms doesn't make you better prepared to do it yourself. The upshot is a variant of the too-big-to-fail theory: Many investors simply have nowhere else to go. Pardon me for a second for imagineering, but it seems like the combination of a discount brokerage through which one could make ETF or closed-end fund purchases - which would negate most of the downside of up front commissions - would be very competitive as a 401 (k) competitor. Given the facts stated above, mutual funds NEED competition. And any reform that does not encourage and engender greater competition for our investment dollars would be lacking a key ingredient. And while we are doing some reforming, do not forget issues like the lack of timely short-selling information for small investors [see Data Wall Street's Slow to Share - Michael Brush, MSN Money] and the possibility the funds companies are up to other suspicious behavior [see Funds Play Favorites - Mark Hulbert, NY Times]. Why not some DRIP reform [see Avoiding DRIP Fees - Terri Cullen, WSJ] that allows DRIPS for ETFs or pre-packaged stock bundles for convenient sector balanced investing? Funds need competition. And this debate has not reached a point where we - the investing public - are asking for the right reforms [see Independent Directors Are Not a Cure - Ian McDonald, WSJ for what Warren Buffet thought about independent directors would do to solve Enron type problems.] Finally, why not some reform that makes proxies a good bit more readable [see When Reading Proxies - Berkowitz & Rampell, WSJ] To some extent, we already have the power to make the changes we want to see in this world. But we are overwhelmed by a competing power - intentional obfuscation.
But Justin Ficken [one of several Prudential Securities brokers charged with civil fraud by both Massachusetts Secretary of the Commonwealth William F. Galvin's office and the SEC on Nov. 4th] told Massachusetts regulators in a deposition about "a document [in which] MFS states, 'These funds are free to be market timed.' " From Landon Thomas, NY Times 12-09: "I know MFS's tolerance of exchanging those funds was in place prior to my getting involved in market timing," MFS, which has $175 billion in assets under management, said in a statement yesterday that firm officials did not monitor daily trading in 11 large stock and bond funds because they "concluded that frequent trading in these funds would not be disruptive to portfolio management and harm fund performance." MFS has begun monitoring those funds, the firm said. There is no evidence that MFS insiders were timing, Sun Life said. From John Hechinger, WSJ 12-09: State and federal regulators are investigating whether MFS allowed timing as a way to increase its assets under management - and consequently its fees - at a time when its overall business was declining in a bear market. MFS's $134 billion under management is down 17% from its early 2000 peak of $162 billion. Federal investigators believe senior managers at MFS were aware of the policy, these people said. In its 2002 fiscal year, which ended Nov. 30, Class A-share investors bought and sold shares valued at nearly six times as much as the entire fund, according to data firm Lipper, compared with the average industry redemption rate of 41%. [With a turnover of 12 times the industry average, of course senior MFS managers knew about the market timing.] From Landon Thomas, NY Times 12-09: The more restrictive language in MFS's prospectus could allow regulators to argue that not only did the company fail in its duty to its shareholders but that it should have informed the fund's trustees. "If a fund company such as MFS knowingly sold securities in material contradiction to its prospectus, that's fraud under federal securities laws," said Roy Adams, a lawyer who has represented a number of mutual fund companies. "Any time you have a practice that is materially inconsistent with the prospectus, the trustees have to know about it."
So the biggest fund company violators just didn't care about getting caught, because the SEC with the support of Congress made sure that "mini-wrist slaps" are all the punishment the violators get, which, while infuriating and discouraging investors, has little effect on the violators. For example, Morgan Stanley got an itsy-bitsy SEC wrist slap of $50 million in the recent settlement for failing to disclose that they were unethically rewarding brokers for peddling in-house funds. But as BusinessWeek pointed out, that "litigation won't make a dent in profits." Why? Morgan Stanley makes $14 million in net profits every day. So they can afford to be arrogant and continue to find other ways to cheat fund investors to recover those little losses. Even the past three years, as investors lost over 40% on equity funds during the bear market, fund managers were giving themselves an average 35% increase in pay. [It is a statistic like this that should make us all start yelling - "I'm Mad as Hell, and I am Not Going to Take it Anymore!] Late Trading and market timing are are not the real problem folks ... expenses are the big killer. Fund expenses cost investors $72 billion annually versus a mere $5 billion in damage done by the illegal trading schemes, says Jack Bogle. After sales commissions, transaction costs, management fees and expenses, and taxes - less than two-thirds of your fund's returns get into your pocket, probably much less. [Another statistic worth yelling about.] More of Fees/Espenses Christopher Oster & Karen Damato, WSJ 12-11 There is little evidence that most investors pay attention to costs in selecting funds, focusing far more on short-term performance records as the reason to pick one fund over another. A major impediment to understanding fund fees is that they fall into multiple categories, which sometimes overlap. There are charges that compensate financial advisers and other fund sellers, for instance, and there are other expenses subtracted from fund assets to pay for portfolio management and other operations. Among the complications: Some charges to compensate fund sellers are subtracted from fund assets. And other costs of fund investing - most significantly, securities-trading costs - aren't included in the standardized calculation of a fund's annual operating expenses. Trading costs typically contribute 0.70 percentage point to the annual costs of owning a stock fund.
Of particular interest are corporate or municipal bond funds whose net asset values stay mysteriously inert even as the United States Treasury market is gyrating wildly. Investors in funds whose net asset values have not reacted to major moves may be paying or receiving the wrong prices. Moreover, stale prices in bond funds provide fine opportunities for market timers who jump in and out of funds to take advantage of out-of-whack prices. A case in point is what occurred in the Treasury market last August. During the first week of the month, Treasury securities maturing in five years yielded between 3.1% and 3.22%. The following week, however, Treasuries fell and their yields moved sharply higher. By Aug. 15, yields on the 5-year Treasury had jumped to 3.4%. What happens in the United States Treasury market ripples through other parts of the fixed-income world, affecting prices in corporate, mortgage-backed and municipal securities. Yet some bond funds appeared to be oddly impervious to the August moves. Consider, for example, the Franklin AGE High Income fund, which invests in speculative-grade debt. From Aug. 8 through Aug. 18, while the yields on Treasuries went from 3.18% to 3.4%, the Franklin fund's net asset value, the price at which it is bought and sold, was constant at $1.87, except for one day when it hit $1.88. And the week of Sept. 8, when Treasury yields fell from 3.34% to 3.14%, the Franklin fund's net asset value stood still at $1.95. Quaker Intermediate Municipal Bond fund (which also invests in high-yield debt) was another anomaly. For three weeks beginning on Aug. 4, its net asset value remained at $4.91. The article below does not concern market timing or late trading, but falls under the general category of brokerage abuse - thus it is included here.
But - and this is the allegation at the center of the government inquiries - he says he was barred from urging clients to sell by Legg Mason lawyers who worried he might appear to be "churning" accounts to earn excessive commissions. Legg challenges McDowell's claims. "We would never prevent a financial adviser from liquidating client positions in clients' best interests," said Peter Bain, the firm's chief administrative officer. McDowell's claims have prompted investigations by South Carolina Attorney General Henry McMaster and his Maryland counterpart, Joseph Curran. Any brokerage might worry about an employee's stated intention to advise huge, across-the-board stock liquidations. Nobody knew if the market would pop back or not, for one thing. Also, large-scale trading can be a sign of stockbroker abuse and might be especially suspicious with unit trusts, which command big up-front sales fees and are designed for the relatively long haul. Why didn't McDowell tell clients or regulators about the alleged ban on selling UITs? He couldn't, McDowell said, because Legg had muzzled him. His bosses forbade him to raise the subject of UITs and sometimes checked with customers afterward to make sure, he said. So why didn't McDowell quit? By staying, McDowell said, he thought he could be a "thorn in the side" of Legg and force the firm to repay his customers. There was also the matter of McDowell's own wallet. If he left Legg, he would have had to repay a substantial portion of his $625,000 signing bonus - although he says that was not his main reason. McDowell eventually was fired. In August 2002, he said, he responded to regulators inquiring about a customer complaint by writing a letter detailing allegations of a UIT trading ban. Legg officials ordered him to change the letter, he said, and terminated him when he refused. Meanwhile, McDowell has taken on what amounts to another full-time job: Trying to interest law enforcement officials, journalists, former clients and Legg's board in his claims of wrongdoing. He has all but invited former clients to sue him and Legg, offering to be a witness. About 20 of his former customers have settled with Legg for small fractions of what they lost, McDowell says, because they don't know the full story. Legg declined to comment on the litigation or say how many former McDowell clients it has settled with, although it says in legal documents it may seek to recover at least $1.5 million in settlement costs from the former broker.
[From Kathleen Day, Washington Post 12-04: SEC Chairman Donaldson said the SEC will vote early next year on a series of other proposed rules, including one requiring every fund board to have a chairman and stipulating that 75 percent of its directors are independent from a fund's management company. He said the SEC also will consider requiring fund managers to disclose more information to shareholders about fees and other costs and giving independent directors the right to hire their own staffs.] With the exception of the disclosure proposal - which no one seems to have significant objections to - there are some serious concerns about the SEC's suggestions. Cut-off Unfair to Retirement Plans & West Coast The 4 p.m. cutoff has a lot of critics, and for good reason. Providers of employee benefits note that virtually all trades into 401(k) and other retirement plans would be processed a day after the order is entered, due in large part to the intermediaries involved and the way in which such trades are aggregated to make the money movements efficient and cost-effective. The new rule requires that funds - and not those intermediaries - get the order by 4 p.m., meaning any trade made through a broker or in a retirement plan would almost certainly have to be placed by 2 p.m. to be certain of capturing the current day's price. Obviously, that's a big challenge for West Coast investors. Opponents are outraged at the prospect, saying investors will pay higher prices because of the transaction delay. It's a valid concern. But Vanguard founder Jack Bogle notes that if a trade is delayed by a day, history suggests it will be completed at a higher price about 51% of the time, and prices will move down about 49% of the time. Compliance vs Fees The compliance issues have an unspoken but sticky component to them, too. If fund firms need additional compliance officers, shareholders will pay for them. Say hello to higher costs, just at a time when the regulators are shining a spotlight on fees. It's hard to get firms to reduce costs when you are giving them additional duties, and investors as a whole will benefit more from cost-cutting measures than from stepped up compliance. As much as the fund scandal has made headlines, it is still a small number of funds out of a huge population that have been directly squeezed here. Says fund industry consultant Geoff Bobroff: "Every potential solution has consequences and costs. The people in Washington are focused on stopping the problems, but they have to be careful, because the disease isn't killing anyone, but the cure just might. The problem is that we won't know it for certain until after the rules are in place."
Mutual fund companies tried to stop Mutuals.com - 294 mutual funds complained about the trades Mutuals.com was placing, and several banned specific Mutuals.com clients outright, the SEC said. But the firm simply assigned its clients new account numbers and, when the fund companies complained again, created two new brokerage divisions so that it could submit trades under a new name, the filing said. The firm also allegedly helped at least one client engage in illegal after-hours trading, the SEC said. In this case, the fund companies were actively trying to prevent the market timing, the SEC and industry officials said. The American Century Funds tossed out a Mutuals.com account for too-frequent trading and then later refused to open another account under another name, said chief executive William Lyons.
The now-questionable advice was provided by a handful of law firms, including such well-known firms as Akin Gump Strauss Hauer & Feld LLP and Piper Rudnick LLP, the same people said. The counsel was based on interpretations of rule 22c-1 of the Investment Company Act of 1940. Although the legal advice could help the traders who obtained it limit the criminal or civil penalties they face for engaging in such trading, regulators have concluded otherwise, maintaining that trading after 4 p.m. is flatly illegal. The legal advice from both law firms relies on a reading of rule 22c-1, which says that mutual-fund trades have to be priced "based on the current net asset value ... which is next computed after receipt of" an investor's buy or sell order. The legal interpretations noted that many mutual funds don't calculate and publish their per-share price until as late as 5:30 p.m. or 5:45 p.m., according to one lawyer familiar with the advice. Therefore, the law firms told clients, late trading in funds that don't calculate and publish per-share prices, or net asset values, promptly at 4 p.m. might be permissible until 5:30 p.m. or 5:45 p.m., "as long as you get [the order] in before they do the computation," the same lawyer said. So far this year, only 7.6% of mutual funds have transmitted daily prices to the Nasdaq mutual-fund quotation service before 5 p.m., according to the Nasdaq Stock Market. An additional 45.8% of funds transmitted their daily prices from 5 p.m. to 5:30 p.m., Nasdaq said Monday, and a further 40.9% did so from 5:30 p.m. to 5:50 p.m.
So the SEC approved Rule 12b-1, which allowed funds to begin charging existing shareholders a fee to pay for increased efforts to market the portfolios. In theory, faster asset growth would mean a mutual fund would realize economies of scale in its overall expenses - that is, spreading expenses over a bigger asset base. It sounded like a win-win for management and shareholders. Moreover, when the SEC approved 12b-1 fees, it did so with the idea that they would be temporary - lasting only long enough to make the win-win scenario real. Yet 23 years later, 12b-1 costs are as permanent a fixture as any on the fund-industry landscape. About two-thirds of all stock and bond mutual funds levy the fees. A 12b-1 fee can reduce an investor's fund return by as much as 1 percentage point a year. According to a 2002 survey by the Investment Company Institute, the funds' trade group, 63% of 12b-1 fees went to compensate brokers. Before 1980, investors who bought a fund from a broker typically paid an up-front commission of up to 8% of the purchase amount. But the industry, and Wall Street, knew that such commissions posed a marketing problem. Americans like to pay on 'time.' They don't like to pay a big wad up front. The 12b-1 fee solved that problem: Brokers could sharply reduce or eliminate their commissions. In place of the commissions, investors would pay up to 1% every year in 12b-1 fees to compensate their brokers. Morningstar calculates that the average stock fund's 12b-1 fee takes 0.44% of assets each year. Added to general portfolio management expenses, that lifts the total annual "expense ratio" of the average stock fund to 1.58%, the firm says. There is a more basic problem with ongoing 12b-1 fees, some analysts say: If the purpose of the fees has been to help a fund grow in size, has that served the fund's existing investors? As funds grow larger, their performance often suffers, says Geoff Bobroff, head of fund research firm Bobroff Consulting. Owners of large funds may end up with portfolios that, at best, track major market indexes - but at higher net cost to investors.
Over the past few years, "growth-fund managers went from the belle of the ball to facing terrible returns and huge outflows from investors," says Don Phillips, managing director of investment-research firm Morningstar Inc. "It may have made them more susceptible to cutting deals to get assets in the door." Fund analysts note that some of those most deeply involved in the current share-trading investigations are the same fund companies who took the biggest risks with their investors' money during the tech-stock boom. Janus's Mercury fund returned 96% in 1999 and then lost more than 22% in both 2000 and 2001. Pilgrim Baxter & Associates' PBHG Growth posted a 92% return in 1999 and slumped to losses of 23% and 35% in the following two years. Putnams' OTC Growth was up 125% in 1999, then down 46% and 51%. Not surprisingly, growth funds also have been hit by withdrawals over the past several years. Growth-fund managers as a group saw net investor redemptions of $39 billion in 2001 and 2002, while value funds had net inflows of $86 billion. Helping some growth managers to offset those outflows were offers from hedge funds that agreed to "park" millions of dollars in other funds managed by the same fund companies. Prices of U.S.-traded stocks can be stale, too. "The last trade on a stock isn't necessarily 3:49 - it may have been 1:30 in the afternoon," says Roger Edelen, a former associate professor at the University of Pennsylvania's Wharton Business School who co-authored a 2001 paper that examined such pricing problems in mutual funds. As a result, he says, even U.S.-traded stock prices don't necessarily reflect the full extent of a late-afternoon rally, meaning that the mutual-fund share prices set at 4 p.m. may be undervalued. So while market timing has often been associated with international funds, it is becoming clear that many big timers conducted trades in domestic stock and bond funds. In fact, based on information made public so far, relatively few of the mutual funds hit with timing activity turned out to be international funds. Instead, timers more frequently targeted funds that were often growth-stock funds, or in some cases, high-yield bonds funds. At Federated Investors Inc., for example, the company said it told hedge-fund Canary Capital Partners LLC from day one that no market timing would be permitted in Federated's international funds. Nevertheless, Canary agreed to a deal where it was permitted to market-time six Federated domestic-stock funds. Canary went on to make 46 round-trip trades - in-and-out trips - using the Federated domestic-stock funds. Some observers say the trait most clearly highlighted in the share-trading probe is the extent to which some fund companies would go to try to attract investor dollars, which in turn boosts the management fees generated for the investment companies overseeing the funds. "It's the hot-money shops," says Harold Evensky, chairman of Evensky, Brown & Katz, a financial-planning firm. "It's not surprising that that's the kind of culture, where those who are prepared to step over the line are in a high-growth, greed-oriented culture."
Among the market timers were Canary Capital Partners [which also admits to 'late trading' of Invesco funds through an intermediary - See posting that immediately follows] and customers of American Skandia, which set up investment vehicles that permitted such trades, according to documents released by Mr. Spitzer and former fund managers. A spokesman for Prudential Financial, which acquired Skandia in May, said that Prudential is in the process of reviewing Skandia's businesses following the acquisition. I edited this story down by more than 50%, but it is still a long posting. The previous story [Why Domestic Growth Funds Were Tempted by Timers] covers most of what you will read here. But even though it is duplication, it will be worth your time. Ask yourself if Invseco crosssed the line, and - if so - where did they do it. I posted my opinions during the story. A Switch to Growth Stocks Brought the Timers For decades, Invesco was a sleepy outpost in the burgeoning fund industry. Invesco's style began to change as the bull market went into full swing. In 1997, Invesco merged with AIM funds to form Amvescap. One year after the merger, the former CEO retired and was replaced by Mark Williamson, a former mutual-fund executive at NationsBank. The new chief executive ramped up the marketing of Invesco's growth-oriented funds. Assets jumped 50% in his first year to $31 billion at the end of 1999. That translated into increased management fees, typically 0.5% to 0.75% of an investors assets. The push for growth ushered in the market timers. Former fund manager Jerry Paul estimates that $200 million of the $1 billion in his high-yield-bond fund came from timers who traded rapidly in and out of his fund. "It was a pain," he says. Mr. Paul left Invesco in January 2002, and now runs his own hedge fund. Mr. Paul says he began keeping a higher percentage of liquid investments in his fund to offset the trading of timers. This lowered his returns since carrying these lower-yielding investments reduced the amount of money he had available to invest in higher-yielding bonds in a flourishing market. "It messes with your performance," he says. "You had to carry more cash because you knew you had hot money," he says. "I knew it would disappear." Typically, he says, the timers kept their money in for less than two months. He boosted his cash to between 5% and 10% of his fund's assets, compared with the 2.5% he would have preferred. The Attempt to Keep Timers Out At Invesco, Mr. Paul and several other senior fund managers began sharing notes about the money flowing into their funds and the topic began cropping up at early-morning investment meetings. John Shroer, then head of the $3 billion Health Sciences fund, believed $10 million of his fund was being traded by timers. He asked Invesco's marketing department to prepare a spreadsheet showing the trades of overly active investors. He was able to identify roughly 10 investors who were violating the company's trading policy, a former fund manager says. Some portfolio managers at Invesco were able to keep market timers at bay. Mark Greenberg, manager of the $1.2 billion Leisure Fund, says he kicked out market timers more than one dozen times and made it clear to Invesco's back-office and client-contact employees that the timers were not welcome in his funds. "There are bad market timers and it's not something I want to mess around with," he says. Each time he asked to have market timers removed from his funds, he says, Invesco complied with his request. Tension between the fund managers and Invesco's senior management boiled over at a series of meetings at Invesco's Denver headquarters in 1998. At one, Mr. Paul blasted the firm's practice of allowing market timers to freely move in and out of Invesco funds. "Market timing is not good for long-term shareholders," he recalls telling senior managers. Eventually that year the fund managers persuaded their bosses to push back against the timers. For three of its funds, Invesco imposed fees of 2% for cashing out shares that were owned for three months or less. The fees were to stave off "short-term trading that had the potential to harm fund shareholders," said Invesco spokesman Mr. Kidd in the statement. The First Deal with the Devil But then the market timers tried to sneak in the back door, say former fund managers. Assuming a variety of names, they invested chunks of money in amounts just under $2 million, so they could avoid detection by Invesco. By the spring of 2002, trading by market timers was more pervasive than ever, say the former fund managers. By that point Invesco was striking agreements with some market timers, giving them the right to rapidly trade certain Invesco funds. The company says it was able to do this because exceptions to the guideline limiting investors to four exchanges annually were spelled out in the company's prospectuses. The company reserved the right "to modify or terminate the exchange policy, if it is in the best interests of the fund and its shareholders." At the time, senior company officials didn't officially announce the turnabout to fund managers, but instead informed them "on a case by case basis," according to Mr. Kidd. A Falling Market Changes Invesco's Bargaining Power Market conditions had dramatically changed since the company had taken steps to throw the market timers out. The bear market had caused investors to flee some of Invesco's top funds, and the company's assets had plunged from a peak of $45 billion in August 2000 to $14.8 billion in March 2003. Invesco says the agreements with market timers didn't amount to a quid pro quo. "There was never a requirement that an approved investor had to maintain any investment with a particular fund or any other Invesco fund in exchange for additional trading capacity," the company said in its statement. Trent May, then the manager of Invesco's Endeavor and Blue Chip Growth funds, says he knew the timers had gotten their foot back in the door when Mr. Miller, the company's chief investment officer, visited his office in the spring of 2002 to talk about an investor who wanted to put money into his $100 million Endeavor fund. Timers Beging Changing Trading Strategy "They were going to be allowed a certain number of trades," says Mr. May. He recalls that Mr. Miller told him to buy two exchange-traded funds, "QQQs" and "SPDRs," funds that mirror large swaths of the stock market. That might make it easier for Mr. May to quickly get in and out of the market when timers moved money in and out. But Mr. May says he resented the suggestion because it was his job to pick stocks, rather than put shareholders' money into index funds. Mr. Miller did not return phone calls seeking comment. Fund Managers in Hell By mid-2002 Invesco's fund managers were regularly seeing signs that market timers had moved in or out of their funds. At 7 a.m., they received e-mails from the trade-processing unit describing their funds' holdings. If new money from investors had arrived the previous trading day, a fund's cash level would rise. If investors withdrew money, the fund's cash level would fall. Mr. May says he regularly saw 5% [$5 million] swings in the amount of cash flowing in and out of his fund. On mornings when stock-market futures were trading lower before the market's opening bell, indicating the stock market would open down, Mr. May worried that the timers would pull a big slug of money out of his fund. If the cash level in Endeavor was not sufficient to cover the withdrawals, Mr. May would have to borrow money from Invesco to cover the shortfall. He would then be forced to sell stocks quickly in the declining market to repay the loan, a move he says would yield a lower shareholder return than he would have produced had he not been forced to sell. If the story would have ended here, I would only fault Invesco with this - Rome was burning [market timers were stealing from us average investors] and you did not let us know. Up to this point, it was the intermediaries who processed the late trades that were the problem. You [Invesco and other fund mangers] were even fighting the problem. But even at that point, you should have let us know. And now things go even further down hill for Invesco. The Second Deal with the Devil Brian Hayward, another fund manager, also noticed in mid-2002 that the company had changed its approach to market timers. At that time, according to Mr. Hayward, he had a discussion with Invesco sales manager Michael Legoski, who acted as a liaison between big investors and the company. Mr. Legoski told Mr. Hayward that a new investor had committed to keep $400 million in assets at Invesco in exchange for the ability to rapidly trade its funds, according to Mr. Hayward. Mr. Legoski went on to say that the investor, whom he did not name, wanted the ability to trade as much as $50 million through Mr. Hayward's $300 million telecommunications fund, recalls Mr. Hayward. Eventually, Mr. Hayward convinced management to decrease the amount the investor could trade through his fund. Hayward SHOULD have resigned instead of let this happen. Invesco had been dancing on the head of the pin of the ethical gray area up till now. Here it was crossed. This is criminal in my opinion. The moral lesson - spend enough time in the ethical gray - and the area suddenly appears to grow. Some Invesco fund managers think the rapid trading reached a peak early this year. One morning in early January, when the stock market was up strongly, Mr. Hayward opened his e-mail and saw that $18 million had moved into his portfolio overnight, boosting his cash level to $34 million. Futures trading on the S&P's 500-stock index indicated that the market would open sharply higher. At the end of the day, he calculated that if the $18 million in new funds from timers hadn't been put in his fund - which meant that a smaller percentage of his funds assets were invested in stocks - his return for the day would have been $1.2 million higher. Before mid-2002 the amount of money coming in and out of his telecommunications fund each day was well below $1 million. He typically kept a cash cushion of $7 million. By early this year, he had boosted his cash level to about $14 million. Invesco acknowledges that fund managers kept larger cash positions because of the timers' trading, but disputes that the extra cash hurt shareholders. It has been said that 'there is never one cockroach'. This has been true of the breadth of the scandal - several hedge fund and mutual fund companies are involved. It is true of the depth of the scandal - it is more than just late trading and market timing. The Hulbert article about 'Funds Play Favorites' makes me worry if the depth is expanding as fast as it should, because the 'favorites' angle has yet to be dwelled upon the Spitzer or the SEC . The area of the 12-1b charges are being looked into - but Congress did little or nothing to address that. There should be caps on those fees, and large funds should never have them. Let's do this scandal right. Let's find all the cockroaches. Late Trading at Invesco Puliam & Lauricella, WSJ 12-02 At 6:31 p.m. on Jan. 13, Canary placed orders to sell big blocks of two Invesco funds, according to a copy of one evening's sell orders made public by Mr. Spitzer. In these trades, at least $90 million of shares in Invesco Dynamics fund and $23 million of shares of the Invesco Health Sciences Fund were sold. The trades were placed through an intermediary, the Bank of America trading system. Dynamics, on Dec. 31, 2002, had roughly $3.47 billion in assets, according to Morningstar. Health Sciences had a $975 million portfolio. A spokeswoman for Bank of America declined to comment. Mr. Stern appears to have avoided a drop in the price of Health Sciences shares. The net asset value of that fund dropped from $33.89 on Jan. 13, to $33.85 on Jan. 14. Invesco says it was unaware of any late trading. Late Trading Restitution Riva Atlas, NY Times 12-07 Spitzer says that all of the management fees earned by fund companies during periods of improper trading should be returned to investors. At the moment, though, companies like Janus Capital and Bank of America have promised to return only the management fees on the fund shares that were improperly traded, a much smaller sum that could wind up representing just pennies to the average investor. In a suit against Invesco Funds Group, the attorney general sought the return of $161 million in management fees earned over two years. At the moment, though, companies like Janus Capital and Bank of America have promised to return only the management fees on the fund shares that were improperly traded, a much smaller sum that could wind up representing just pennies to the average investor. Even if Spitzer gets the larger amount, these sums could end up as small amounts after they are divided among hundreds of investors, particularly those who may have owned a fund for just part of the period of wrongdoing or who have since sold their investments in the fund. Take the Invesco Dynamics fund, which, according to Spitzer and the SEC, was heavily used by frequent traders, in violation of limits in its prospectus. Russel Kinnel, the director of fund research at Morningstar, suggested a way of calculating possible payouts for investors under Spitzer's principles. The fund charges investors 0.46 percent a year in management fees. An investor with $10,000 in the fund for a year may get $46 in restitution from the fund company, assuming the fund was held for the entire year. Quick Facts, Stats & Opinions Current and retired members of the Federal Reserve's employee thrift plan have been buying and selling shares in the plan's international mutual fund at such a pace that Fed officials have put out pleas that they curb the practice. While it isn't the first 401(k)-type plan in which investors have traded frequently, disclosures of rapid fund trading by Fed employees could raise new questions about how fund firms handle accounts of retirement plan participants who work for Wall Street firms or government institutions that can affect markets. Indeed, the Fed's thrift plan already features tough rules that prohibit short-term trading of bond funds, which are much more directly affected by Fed policy. (Aaron Lucchetti, WSJ 12-09) Wells Fargo said it found 1,600 attempts by customers during the last three years to frequently trade mutual fund shares in violation of fund rules. The bank said all attempts at market timing were rebuffed. (LA Times 12-06) While Congress is running up the biggest budget deficit in American history, why did they cut $30 million out of the budget for the Securities and Exchange Commission? If Congress and the White House really cared about protecting investors' rights, they wouldn't be taking money away from the SEC, they'd be taking the SEC to the woodshed for not making better use of its resources. The $30 million SEC cut is a pittance compared with the amount investors lost because some mutual fund permitted what amounts to insider trading. It's a fraction of what mutual fund investors were overcharged in commissions by brokers who didn't give them discounts they were entitled to based on the big investments they made. [Audits by the NASD - not the SEC - found that about 1 in 5 investors didn't get the discounts to which they were entitled.] (Jerry Knight, Washington Post 12-01) Of the 10 fund companies that have taken in the most new money this year, just one - the One Group funds in Chicago, operated by Bank One - officially has been implicated in the fund scandal. Meanwhile, well before fund companies including Putnam and Janus had been implicated, they had been suffering net outflows of cash this year primarily because of poor portfolio performance. (Tom Petruno, LA Times 11-30) So how much did investors pay to stock and bond fund managers in the most recent 12 months? More than $35.2 billion [or 0.86% of assets], according to Max Rottersman, president of FundExpenses.com. And the total does not include sales charges on broker-sold funds. The largest is adviser fees, which totaled $21 billion or 0.52% of assets. The self-serving 12b-1 charges fund companies use to attract new money, totaled $9.2 billion, or 0.23% of assets. Shareholder servicing fees added $5.6 billion, or 0.14%, and custodian fees brought in $537 million, or 0.01%. (Gretchen Morgenson, NY Times 11-30)
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