NEW YORK (Money Magazine) -
Like Joshua shattering the walls of Jericho, in early September New York State Attorney General Eliot Spitzer shook the mutual fund industry to its very foundations.
According to Spitzer, Bank of America's brokerage unit helped hedge fund manager Edward Stern trade the bank's Nations funds at earlier prices after the market had closed.
Such "late trading" is flagrantly illegal. (One former B of A broker has been charged with two felonies.)
Meanwhile, Spitzer alleged, Janus, Nations, One Group and Strong had let Stern own their funds for only days at a time; while this "market timing" is legal, it contradicts the funds' stated policies.
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Spitzer also charged that Strong leaked to Stern the confidential lists of some of its funds' holdings, which enabled Stern to short-sell some of the stocks in the funds.
This may be only the tip of the iceberg. Stern settled the charges for $40 million in penalties and restitution without admitting wrongdoing. But he has implicated at least two dozen other fund outfits.
And MONEY has learned that one of the world's leading investment firms -- Wilshire Associates of Santa Monica -- was engaged for years in massive rapid-fire trading of mutual funds that raises disturbing questions about ethics and conflicts of interest.
There seems to be no end to the issues raised by this scandal.
How much financial damage might this conduct have caused investors like you? Did only a few fund companies break the rules or was it an epidemic?
How worried should you be as a fund investor? What can regulators and fund companies do to protect you against this kind of abuse? What can you do to protect yourself? Should you abandon mutual funds altogether?
Tallying up the harm
Let's start with the damage. Long-term fund investors are hurt in several ways when short-term traders like Stern barge in and out.
The fund incurs commissions and other trading costs that eat away at returns; the managers have to keep extra cash on hand, lowering the fund's gains in a rising market; and big short-term redemptions can create fat tax bills for the investors who stick around.
How much does rapid trading cost shareholders who stay put? Eric Zitzewitz, a finance professor at Stanford who has studied the damage done by market timers, estimates the tab at $5 billion a year.
He also reckons that investors in regional foreign funds -- portfolios investing only in Japan, say -- may have had their returns cut by up to 2.3 percentage points a year as timers stampeded in and out.
But it's important to realize that for most investors, any damage to a single account is likely to be minuscule. Unless your entire portfolio is in regional foreign funds, it's doubtful that these shenanigans cost you anything close to 1 percent of your money.
Janus, Nations and One Group have already pledged to make "restitution" for any financial harm their actions may have caused; if you own one of their funds, that compensation is unlikely to buy you much more than a cup of coffee at Starbucks.
While the monetary harm to any one of us was small, the psychological damage is incalculable. The premise upon which mutual funds are sold to individuals -- here's your chance to get treated just as well as a Wall Street big shot -- has been exposed as a pathetic lie.
The "mutual" in mutual fund is supposed to mean that every investor is assured of equal treatment. While that was never entirely true (as I and others have often warned), it has never seemed like more of a mockery than it does in light of the Spitzer investigation.
If poor slobs like you and me tried to trade more than four times a year, most fund companies would put us on a blacklist and forbid us from ever owning their funds again.
But when Eddie Stern and his multimillion-dollar hedge fund showed up, Bank of America gave him a customized computer terminal -- and, most shockingly of all, lent him roughly $300 million to finance his allegedly illegal trading of the bank's Nations funds.
If you or I rushed to sell a holding in Janus or One Group funds, we would get whacked with a 1 percent or 2 percent redemption fee -- which the firms claim is a mandatory penalty for anyone who buys and sells within 90 days.
Yet Eddie Stern got to trade these funds like wildfire without paying the penalty. The prospectuses of all four fund companies pledge that the firms will be vigilant in preventing fast traders from buying their funds -- but the firms' own e-mail records, exposed by Spitzer, reveal Bank of America, One Group and Janus executives slobbering over the prospect of the fees that Eddie Stern's account would generate for them.
As Spitzer said to MONEY, all these companies "egregiously violated the fiduciary duty they owe to their mom-and-pop investors."
Unfortunately, the rot goes much further than four fund groups. "Lots and lots of names have come up [for further investigation]," Spitzer told MONEY. "There are big names involved that would surprise people, entities and institutions that otherwise have pristine reputations."
MONEY called more than a dozen of the nation's biggest mutual fund companies for comment.
Steve Norwitz of T. Rowe Price says, "We are in the process of examining all of our relationships. We routinely watch trades and have very restrictive guidelines [to prevent such activities]."
TIAA-CREF spokesman Tom Pinto says, "We strongly discourage market timing, and we do have certain trading limitations in place."
Chuck Freadhoff of American Funds says, "We have people who watch for trading patterns that appear [to show] that someone is trying to time the market and trade to the detriment of shareholders."
It turns out that one of the biggest names in the business of fast trading of mutual funds is one of the most influential firms in the asset managment industry.
Wilshire Associates wears many hats. The 31-year-old company manages the Wilshire 5000-stock index, the best and broadest measure of the U.S. stock market; the firm also sponsors a $103 million index fund based on its own benchmark. Wilshire sells advanced software to money managers, pension funds and other investing giants.
Perhaps most important, Wilshire recommends investment managers to pension funds and endowments, thus influencing which firms get to manage billions of dollars.
Until 2002, Wilshire was also a money manager. According to several people familiar with the firm's operations, at least a decade ago Wilshire founder Dennis Tito began experimenting with a highly complex trading strategy.
Tito's tool was index futures -- securities based on market benchmarks like Standard & Poor's 500 or the Russell 2000 indexes.
These index futures closely track the value of their underlying baskets -- but, like all markets, this one is not perfectly efficient. Sometimes the index futures are "rich," or overpriced by a tiny fraction.
Tito realized that he could sell the index futures short, or bet that their prices would fall -- virtually a sure thing, since ultimately the prices of the futures and the underlying index should converge.
At the same time, without paying any commissions, he could buy a bundle of mutual funds whose stockholdings closely resembled the makeup of the market index.
With this hedge, Tito locked in a tiny gain, nearly risk-free, as the prices of the futures and the index converged at the 4 p.m. market close.
The strategy worked, and Wilshire was electrified by the gains on these lightning-fast trades. One person familiar with the strategy recalls hearing that it generated annual returns in excess of 100 percent.
According to its regulatory filings, by year-end 2000 Wilshire had borrowed $73 million from Citibank, $65 million from Sanwa Bank of California and $35 million from Prudential Insurance -- giving it a total of $173 million in leverage.
People familiar with the firm say that most, if not all, of the borrowings were used to finance Wilshire's twinned trades of futures and funds.
The firm typically put at least $100 million to work, spreading it across roughly 10 mutual funds, which it held for one to five days on average.
Of course, the excess costs generated by all this hyperactive trading were borne not by Wilshire or the fund managers, but by the funds' loyal long-term investors.
Did Wilshire sneak into the funds it traded? Absolutely not, says someone familiar with the strategy: "Dennis openly told the funds he was going to trade frequently."
None of my sources could identify any of the firms that allowed Wilshire to churn their funds. Wilshire favored small-cap and midcap funds with at least $1 billion in assets, suggesting that some of the biggest firms in the industry may have been involved.
Between 1996 and 1998, three fund companies -- Fremont, Strong and a firm that was never named -- banned Wilshire from trading their funds.
In 2001, Dennis Tito earned 15 minutes of universal fame when he shelled out a reported $20 million to become the first paying tourist in space, joining a Soyuz mission to the international space station. Tito declined money's request for an interview about Wilshire's fund trading operation. Kim Shepherd, a Wilshire spokeswoman, says that the firm "phased out that strategy during the first quarter of 2002."
Does its former strategy of fast fund trading raise any ethical concerns? "Wilshire Associates," says Shepherd, "has always completely and fully complied with all rules and regulations covering our industry. All trading fell within the parameters set out by regulators."
Wilshire would not respond to my inquiries in further detail, but disturbing questions remain: Was it a conflict of interest for fund companies -- who knew that Wilshire might (or might not) recommend them when its clients searched for money managers -- to let Wilshire yank $10 million a day in and out of their funds?
Since the frictional costs of Wilshire's hot trades burned the other investors in these mutual funds, was complying with "all rules and regulations" good enough?
Finally, was Wilshire the only blue-chip institution that whipsawed mutual funds like this? (In 1999, MONEY was told that at least one major European-based bank was doing something similar, but we were unable to pin down the details.)
Whose needs are served?
One thing is sure: The fund industry's protests of innocence ring hollow. Mutual fund companies long ago made an uneasy deal with the devil, publicly discouraging the rapid trading of funds but privately cultivating cozy relationships with itchy-fingered market timers.
In November 1997 the Society of Asset Allocators and Fund Timers Inc. (or saafti, pronounced safe-tee) held its annual conference.
This group, then consisting of more than 170 professional market timers and fast traders, is openly dedicated to "developing and maintaining cooperative relationships with the mutual funds with which our members do business."
And the companies in attendance that day felt just the same way about the market timers.
The conference was sponsored by more than a dozen fund companies.
Fidelity's fund group was not there, but its brokerage division was. Harry Bowdoin, a vice president at Fidelity Investment Advisor Group, told the crowd, "We are dedicated, in all honesty, to serving the needs of advisers like yourselves. I never thought I would feel so comfortable among a group like this."
(Only moments before, the emcee had joked that one of the saafti members in attendance had done 302 fund trades the month before—and most of the audience didn't even realize he was kidding.)
Lisa Laudeman, a Scudder executive, declared that "we're trying to come out of our old personality and step up to the plate and serve you all."
And so it went, as one fund official after another stepped up to sing for his supper. It was painfully clear that, far from being hostile to fast-trading market timers, some fund companies were only too happy to court them. (Fidelity says that Bowdoin no longer works there and that Fidelity "has long been opposed to market timing, not just in our words but in our actions." Laudeman is no longer employed by Scudder, now a division of Deutsche Bank, which says it disowns her remarks.)
Dumpster diving for dimes
What's especially pitiful is that fund companies were often willing to bend the rules for so little gain. Eddie Stern's hedge fund put at least $10 million into Janus funds in early 2002. If Stern kept it in Janus Mercury for only a single day, then Janus (at its management fee of 0.65%) would earn less than $200 from that 24-hour "investment."
And yet Richard Garland, a senior Janus executive, wrote in an e-mail discovered by Spitzer: "I have no interest in building a business around market timers, but at the same time I do not want to turn away $10-$20m!
How big is the deal...?"
We are thus treated to the sad spectacle of millionaires diving into a sewer to grab loose change. (In a statement, Janus CEO Mark Whiston says the firm is "actively re-evaluating our procedures and broadening our steps to permanently eliminate discretionary market timers.")
How to stop timers
So what should be done about all this? For years, the Securities and Exchange Commission has refused to allow funds to charge redemption fees above 2 percent, even though the costs triggered by short-term traders are often much higher.
The regulators should just butt out.
Anyone who can't hold on to a fund for 90 days in a row deserves to pay a 5 percent redemption fee to compensate the long-term investors for the expense of letting him jump in and out.
On another front, the fund industry has ignored all suggestions to disclose how portfolio managers are paid. The Spitzer case shows once and for all how indispensable this information is.
While the amount of a portfolio manager's salary and bonus should remain private, the factors on which his compensation is based should be disclosed in the prospectus. Does he get a bonus if the fund grows larger or if a certain amount of new money comes in? (That's bad.) Or is he paid exclusively on the basis of investment performance? (That's better.)
Finally, the onus is on each of us.
You should not abandon mutual funds; despite all of their faults and the latest scandal, they remain by far the best vehicle for most investors. Nothing else offers as much convenience and diversification in such a low-cost package. But now more than ever, picking a fund involves making character judgments about the people who run them.
Eric Zitzewitz, the Stanford finance professor, found that funds with low expense ratios and boards dominated by independent directors are more likely to crack down on timers.
Here are the signs that greed is not Job One at a fund company:
Minimal hype When a fund's ads blare out its hot returns in giant neon type, force yourself to resist the temptation to grab a piece of that high performance for yourself. Advertising hype tells you a fund is part of a marketing machine where investment results may be secondary.
Low expenses If a fund's annual expenses are above average (over 1.5%), that's a sign of greedy managers and a wimpy board of directors. Such people are more likely to have welcomed market timers in the past and to put their own interests ahead of yours again.
Redemption fees As a long-term investor, you want your fund to kick short-term traders as they go out the door. Lean toward funds that have redemption fees for holding periods of 90 days or less.
Fair value pricing Consider funds whose prospectuses state that they will discourage market timers by using "fair-value pricing" (adjusting overseas prices to reflect late news); among them are Fidelity, Vanguard and T. Rowe Price funds.
Closing doors Lots of money coming in fast will make fund managers rich, but it can hurt investment performance. For a powerful indicator that fund managers don't care only about lining their own pockets, check to see whether they have ever shut any of their funds to new investors.
Insider ownership The best clue of all is how much money the fund company's executives have in their own funds. The industry has ferociously resisted any suggestion that this should be disclosed, but some firms have voluntarily reported that their managers are major investors in their own funds; among them are Davis, fpa, Longleaf and Tweedy Browne.
Speak up Finally, make your voice heard. If your fund firm is implicated in this scandal and its executives won't even apologize for their conduct, contact the directors of the funds and demand that the management company be fired. If none of this brings you any satisfaction, dump your tainted funds and buy a low-cost index fund, where you probably should have kept your money all along. ƒ