Your Fund Vs. Wall Street Legendary investor Michael Price says big brokerages are ripping off mutual funds. And that costs you money
By Jon Birger

(MONEY Magazine) – Michael Price is not your typical venture capitalist. During his 23 years running the Mutual Series funds, Price had little use for trendy technology companies, preferring to twist the arm of a slothful bank CEO rather than pay a premium for a Microsoft or Cisco stock. (His tactics worked: Price's flagship Mutual Shares racked up an annualized 17% over his career.) So when MONEY learned that Price had invested several million dollars of his own money in an Internet start-up called Liquidnet, we wondered whether the man once dubbed "The Scariest SOB on Wall Street" was letting all that Palm Beach ocean air go to his head. It turns out that the 52-year-old is as scary as ever, even in semiretirement.

Liquidnet is a fast-growing online trading network that allows mutual fund managers to swap large blocks of stock over the Internet, all without a traditional broker. Some market watchers think the firm could eventually pose a major threat to Wall Street profits. But Price says Liquidnet is even more important than that. He claims it can save fund investors from getting ripped off.

It's not what you're thinking. Price is as outraged as anyone about the recent mutual fund market-timing scandal. But in terms of actual economic harm, he says, these abuses are small potatoes compared with inflated trading costs, the problem Liquidnet is designed to solve. Price reckons that brokers nick fund investors for upwards of $50 billion a year. "The numbers are huge," says Price.

Follow your money

Let's stipulate right off that, as a Liquidnet backer, Price has an obvious interest in painting the worst possible picture of Wall Street's status quo. But he lays out a compelling case. Generally, when your mutual fund buys or sells a stock, it goes through a broker. Trading commissions, which come right out of your returns, typically run about 5¢ a share. Liquidnet's charge is 2¢. But the real bite, Price says, comes from the market impact of the fund's trade.

Let's say your fund places an order through a traditional broker to sell 100,000 shares of Nike. The broker will probably divvy that order up among multiple traders, who in turn call multiple potential buyers. Trouble is, the more people who know about a big sell order, the greater the risk that a hedge fund or some other opportunist will get wind of the order and attempt to trade against it. How? Usually by shorting Nike stock (that is, betting it will go down) either before your fund's order gets filled or afterward, if they suspect the seller has more shares to unload. That means that when your fund does sell, it will probably get a lower price for its Nike stock. And you end up with a lower return.

Price even alleges that brokerages use their unique knowledge of buy and sell orders to make money at their clients' expense. "Brokers have options departments, block-trading departments, arbitrage departments, and all the time they're positioning themselves against client orders--selling against a big sell order or buying against a big buy order," says Price. "It's their bread and butter." Suffice it to say, brokers don't take kindly to being accused of what sounds a bit like insider trading. "Any implication that we use or share a client's trade information inappropriately is outrageous," says a spokesman at Goldman Sachs.

Securities Industry Association general counsel George Kramer says the kind of trading activity Price describes is allowable, so long as the brokerage is only guessing about future orders. And in an era of falling commissions, brokers need the money. "It wasn't always the business model of the Street," says Bernstein Research analyst Brad Hintz. "But it's become so lately--not out of malevolence but out of necessity."

Game over?

Good fund managers know this stuff goes on and hire canny traders to combat it. "I can't speak for others, but I can tell you we are in the business of trying to win on every trade," says Andy Brooks, who runs the equity trading desk for T. Rowe Price. But Michael Price argues that at some fund companies, at least, nobody really knows what the traders are up to. He especially wants to see fund directors wake up to the problem. "How many directors have ever sat on a trading desk for half a day and asked their trader, Why did you give that trade to that broker?" he says. "Is it because you got the best price? Or is it because he gave you Rangers tickets the night before?"

Liquidnet takes hockey out of the equation, so to speak, by making trades invisible to the Street until after they're done. Liquidnet's Web software is linked to the order-management systems used by nearly all fund managers. So let's say a Vanguard fund wants to sell 100,000 shares of Nike. The moment its trader enters the sell order into the system, Liquidnet instantly scours the buy orders of other Liquidnet members to see if there's a natural match. If it turns out that T. Rowe Price is looking to buy 100,000 shares of Nike, Liquidnet notifies the two firms of the match and gives their traders a brief window of time to anonymously negotiate a trade online. Since most trades are completed at or near the stock's real-time price, the market impact is low.

Only three years old, Liquidnet is now the nation's 19th-largest broker of New York Stock Exchange shares. Its average daily trading volume has more than tripled over the past year to 19 million shares, and its network of participating money managers now adds up to 85% of the mutual fund industry. Indeed, Liquidnet has all the makings of a hot initial public offering, either later this year or in 2005. Michael Price, in other words, has definitely not lost his edge. --JON BIRGER