The mutual fund scandal and you

There seems no end to the mutual fund industry's dirty deeds. Here's what all the fuss is about, how it might affect your portfolio and what you should do now.

By Timothy Middleton

For decades, we've been told the safest way to invest is to put our money in mutual funds. They have become so popular that about half of all American families now own them, often in IRAs or company pensions called 401(k) plans.

Recently, scandals have spread through funds like wildfire, raising questions for individual investors. What have fund managers done wrong? And what are we supposed to do about it?

Although they are the worst in the industry's history, these scandals are easier to understand than you might think. And figuring out what you need to do with your own fund investments is pretty easy, too.

Here's a primer on the scandal to date:

The nitty gritty

Q: Who is affected by this scandal?

A: Potentially half of the American public. In the last 20 years, total fund assets have grown 1,787% to $7 trillion, from $371 billion in 1984. About one-third of fund assets are held in IRAs, 401(k)s and other tax-deferred accounts. The total number of funds available has swelled to more than 8,000 from 1,200.

Among mutual fund companies, one of the world's largest ,Putnam Investments, has been implicated. And some big names in the financial world -- such as brokerageMerrill Lynch (MER,news,msgs) and Bank of America (BAC,news,msgs), which sponsors some of the problem funds -- have been tarnished by the scandal.

Most of the tainted fund companies themselves are smaller. And so far, at least, the very largest fund companies, Fidelity Investments, Vanguard Group and American Funds, have not been accused of illegal or improper activities.

Q: What did they do wrong?

A: The scandals focus on two areas, both of them involving unscrupulous stock-trading practices that siphon money from mutual-fund shareholders at large -- in other words, you and me.

The first area is called late trading. Legally, funds are required to stop accepting new purchases and sales at 4 p.m. ET to get that days price. Funds are priced once a day, at 4 p.m. Any orders placed after 4 p.m. are supposed to be assigned a share value based on the following day's closing price.

But as it turns out, many funds appear to have allowed exceptions -- costly exceptions. The beneficiaries typically were so-called hedge funds, which are essentially independent investment funds run for groups of wealthy investors. In the worst cases, certain hedge funds and other favored investors were allowed to make late-day purchases. What difference does it make? Well, sometimes news breaks after 4 p.m. that will produce big swings in stock prices the following day. Late traders took advantage of events like that.

Legitimate exceptions also have been made, such as to allow pension-plan administrators to forward the days transactions. But these practices apparently spiraled out of control. The Securities and Exchange Commission and some state officials have charged that some late trading was clearly illegal, allowing hedge funds and other large investors to break the deadline repeatedly.

The second abuse is called market timing. Hedge funds and some other investors were allowed to dive into certain funds to capture stale prices -- taking special advantage of time lags among stock markets around the globe. For example, European stocks finish trading several hours before the official U.S. close of 4 p.m. If in the intervening hours American stock prices went up sharply, Europe could be expected to follow suit the next day. Timers would buy the fund today and sell tomorrow to capture this increase.

Q: Those two things don't sound like a big deal. Is this just a tempest in a teapot?

A: No way. Any profits these short-term traders made came directly out of the pockets of long-term shareholders. Here's an example. Assume a mutual fund with $500 million in assets sees its investments rise 2%, or $10 million, during the trading day. After hours, a hedge fund throws in $50 million. Even though that money was never invested, it claims a share of the profits. Now that $10 million profit is spread over $550 million in assets, not $500 million, and a 2% return has become 1.8%. Late-traders walk away with net profits of $900,000, or 9 cents of every dollar earned -- and every penny subtracted directly from the rightful profits of long-term shareholders.

Q: If it hurts shareholders so directly, and the profits all go to the traders, why would the fund companies allow it?

A: In some cases, employees of the fund companies were the traders, according to federal and state charges. The founders of two mutual fund companies, Strong and PBHG, have been ousted on such charges.

In other cases, the fund companies participated in back-door agreements that would benefit both parties. The traders would get special buying and selling access in return for a commitment to invest some of their longer-term accounts with the fund companies. The fund companies -- which earn a small percentage in "management fees" for every dollar invested -- would thus gain more in fees.

Finally, in some cases, fund companies were simply the dupes of stock brokers who engineered the trades for commission income.

What's the punishment?

Q: Is anybody going to jail?

A: Most of the charges so far have been civil, not criminal. (It takes a criminal conviction to land someone in jail.) Authorities have struck deals with some fund companies requiring them to reimburse shareholders who were harmed. Some fund officials and stock brokers have lost their jobs and could be barred from working in the industry again.

Proving criminal charges could be harder and take much longer than the civil actions. Some of those implicated in the scandal have asserted they got legal opinions approving the trading in advance, which would be a strong defense in a criminal case.

All said, some criminal charges have been filed, including actions against officials of Security Trust Co., a Phoenix bank that's been accused of late trading.

Q: How many companies have been dragged into the scandals?

A: Nearly 20. Fund companies include Alliance Capital, Federated Investors, Fred Alger Management, Invesco Funds, Janus Capital, Loomis Sayles, Nations Funds (part of Bank of America), One Group (part of Bank One (ONE,news,msgs)), PBHG, Putnam Investments and Strong Capital Management. Brokerage firms, some of whose employees allegedly orchestrated improper trading of funds shares, include Bear Stearns, Merrill Lynch, Smith Barney (part of Citigroup (C,news,msgs)), US Trust Co. (part of Charles Schwab (SCH,news,msgs)), UBS (formerly Paine Webber) and Wachovia (formerly Prudential Securities).

Security Trust has been ordered by federal authorities to close.

Q: Which cops are going after these guys?

A: The scandals originally surfaced when the New York attorney general's office cracked down on a hedge fund, Canary Partners, on Sept. 3. But the chief regulator of mutual funds is the SEC. Unfortunately, that agency has had to play catch-up with Eliot Spitzer, the aggressive New York attorney general. Nonetheless, the SEC has now filed a number of complaints itself.

In addition, the SEC has proposed new rules that would permit no exceptions to the 4 p.m. deadline. Also, it's considering other rule changes, such as imposing nearly universal redemption fees on funds to discourage short-term trading.

Don't panic

Q: Should I sell all my mutual funds?

A: Absolutely not. Funds from companies that are not implicated in the scandals are probably OK, and only some individual funds at accused firms were involved. Most of the abuses involved funds focused on foreign and domestic-growth stocks. Index, value and income funds were not employed widely by the traders.

Still, you should consider dumping funds from companies where the abuses were the most blatant, and many shareholders already have. Putnam has lost $32 billion in investor assets in the last three months, nearly 12% of its assets.

Q: Do I need to hurry to change my investments?

A: No. If you have built up substantial capital gains in a tainted fund, or would face hefty redemption fees, getting out immediately might be the wrong move. Also, in many cases restitution will be made to the funds, meaning you'll have to be a current shareholder to benefit.

The fallout

Q: Is this scandal going to take the whole stock market down, sort of like Enron helped do?

A: It hasn't so far. Many of the redemptions have come from institutions, such as insurance companies, which have taken their assets in kind, or in the form of securities rather than cash. There has been no widespread selling to meet redemptions from individuals.

Q: How can I be sure there isn't another scandal out there waiting to be discovered?

A: You cant. But don't cut off your nose to spite your face. Most of us are no good at picking stocks to buy, let alone knowing when to sell them. Funds are the best way for most individual investors to benefit from diversification and expert management.


At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.

source: MSN Money

The Sad But Overblown Mutual Fund Scandal

NEW YORK - It's hard to know, but there's evidence that there may be less than meets the eye in the nascent mutual fund scandal.

Yesterday was a big day in the scandal--USA Today called it "cataclysmic"--as the chief executive of Putnam Investments resigned, regulators testified on Capitol Hill and Massachusetts regulators prepared civil fraud charges against former Prudential Securities employees. There was something new, too: Regulators indicated that nearly 450 brokerages have overcharged on fund purchases and ordered them to notify their customers of possible refunds.

The National Association of Securities Dealers, which regulates brokers, announced that it was requiring the 450 brokerages to notify clients that they may not have received so-called "breakpoint" discounts and that they may be due an average refund of $243 per transaction. But the total overcharge is said to be $86 million for 2001 and 2002.

Eighty-six million dollars is nothing to sneeze at. But in the context of the mutual fund industry, it's not a big number--and it's also not clear whether most of this overcharge was a form of fraud as opposed to bookkeeping error. (Note: the mutual fund industry is often called a $7 trillion industry. This is nonsense. The entire U.S. GDP is roughly $11 trillion, and the mutual fund industry does not account for 64% of the total. The big, misleading number refers to assets under management, not industry revenue, which are a tiny fraction of those assets.)

In general, the data relating to the scandal is tossed around with some abandon. In his testimony on Nov. 3 to the Senate Governmental Affairs subcommittee, Stephen Cutler, the head of the SEC's enforcement division, referred to "The unholy trinity of illegal late trading, abusive market timing and related self-dealing practices." These three practices may be a trinity, but late trading (buying shares after the 4 P.M. market close based on after-hours information, while getting the 4 P.M. price) is generally considered illegal, but market timing is not--at worst it is vaguely unethical. What Cutler means by "related self-dealing practices" is not clear.

Cutler also said that more than 25% of brokerage firms that sell mutual funds and 10% of the funds surveyed had permitted customers to engage in late trading that may have been improper. "As my colleagues and I have gathered evidence of one betrayal after another, the feeling I'm left with is one of outrage," Cutler said.

These statements raise two questions: How did the SEC find this out so quickly, and was what they did improper or not? In general, it would seem to require the consent of the funds to allow late trading so that, for firms that merely sell fund shares, to "allow" late trading would seem to be irrelevant.

That mutual fund companies and brokers sanctioned market timing (taking advantage of time differences and price movements in international markets by buying international mutual funds in U.S. markets) by large investors when their own sales documents discourage the practice, that's sleazy. It's fine that Lawrence Lasser, chief of Putnam, a unit of Marsh & McLennan (nyse:MMC - news -people ), was forced to resign and that Prudential Securities (nyse:PRU - news -people ) brokers might be charged. There are too many mutual funds anyhow and if a few go under, it's no loss. Still, it's way too early to suggest that there is something fundamentally wrong about the industry--aside from the fact that most funds don't even equal the market averages.

It's also sad that the geniuses who run hedge funds spend their lives seeking such tiny advantages and are so richly rewarded for their miniscule efforts. This assumes, of course, that they have in fact been rewarded. While Richard Strong said he made $600,000 in three years from his improper trading--much worse than most because it was in his own fund--that was pretty small-time from his perspective.

Edward Stern, the billionaire's son who started the scandal rolling, managed to run his scheme for just three years before essentially closing his hedge fund. It's not clear at all what Stern and the other funds made from illegal practices or from improper practices. Let's hope the corner cutters get drummed out of the business and that they are made to pay back their ill-gotten gains--and fines, too.

But it remains to be seen if the scandal really is big money as opposed to the work of a few hundred grubby brokers seeking a legal, if pathetic, edge.

source: Forbes