Mutual Fund Scandals: Once Again, Individual Investors Are the LosersPublished: September 24, 2003 in Knowledge@Wharton
Recent revelations about late trading and market timing in mutual funds at Bank of America and other fund complexes come on the heels of earlier incidents involving sales incentives for brokers to push in-house funds and some companies’ failure to credit investors with volume discounts on fees.
Is the mutual fund industry going to become mired in the kind of scandal that has afflicted so many public companies over the past few years?
Though the recent scandals are serious enough to deserve remedies, most fund experts say there’s little evidence so far that these problems have cost investors anywhere near as much as shareholders have lost in the scandals involving public companies such as Enron, WorldCom and Tyco.
“I think the mutual fund industry has seemed relatively clean, and I think the reason is that this is not an industry where it is possible to steal a lot of investors’ money,” says Wharton finance professor Philip Bond, who studies corruption.
Nonetheless, the industry does have critics – none more vociferous than John C. Bogle, founder and former chairman of The Vanguard Group fund complex. “What we’ve seen in these scandals is a focus on the interests of the [fund] management company as opposed to the interests of the individual shareholder,” Bogle says.
One of the fund industry’s chief problems, he adds, mirrors that found at The New York Stock Exchange, Enron and many of the other companies that have run into trouble in the past few years: passive boards of directors that are cozy with management and unaware of what’s going on inside the funds they oversee. “The board is in the grip of this vice … in control of the management company,” Bogle states.
Two-timing Hedge Fund
Early this year, the NASD, formerly called the National Association of Securities Dealers, began investigating reports that brokerages had cheated investors out of volume discounts called breakpoints, for purchases of funds requiring a front-end load – a sales commission for the brokers who sell the fund’s shares. Loads typically range from 1% to 5% of the amount invested. Many large brokerages create and manage their own load funds, and brokers can also sell load funds run by outside fund companies, which were not necessarily involved in any breakpoint cheating.
In August, the NASD ordered more than 600 brokerage firms to pay refunds that could come to tens of millions of dollars to investors who did not receive the breakpoints, or reduced loads, to which they were entitled.
In another case, in mid-September the NASD fined the securities firm Morgan Stanley $2 million for conducting illegal sales contests that encouraged the firm’s brokers to push investors to buy Morgan Stanley funds rather than those of competitors. Brokers are legally required to recommend the investments most suited to each investor’s needs.
In the most serous of the recent scandals New York Attorney General Eliot Spitzer earlier this month announced a $40 million settlement against hedge fund Canary Capital Partners for late trading and market timing of funds run by Bank of America and several other companies. The bank permitted the trades in exchange for other business from Canary, Spitzer said. Late trading is illegal while market timing violates securities regulations if the fund company tells investors it prohibits the practice, as the bank did.
The Securities and Exchange Commission, Spitzer and other regulators are investigating whether the practice is widespread in the fund industry.
But as serious as these issues are, Bond points out that they don’t rise to the level of other recent business scandals that have cost investors billions. In fact, the Morgan Stanley case looks fairly innocent next to the big corporate crimes of the past few years, since most people assume that any salesman will push his own firm’s products over others, he says.
In the breakpoint matter, brokerage firms were targeted, not fund companies – although in some cases brokerages are fund companies as well.
While the late trading and market timing case was serous enough to lead to some criminal charges, there is scant evidence so far that many fund companies are deliberately trying to cheat their customers in this way.
“What is funny to me is that academics have known about this for awhile,” says finance professor David K. Musto. “People on Wall Street have known about this for many years.”
Unlike stocks, which change price throughout the day, mutual fund shares are priced just once every trading day, based on the value of the fund’s assets at the market’s 4 p.m. close. To get the 4 p.m. price, an investor must place an order before the close. Orders placed afterwards are filled at next day’s closing price.
In the Bank of America case, Canary, the hedge fund, was allowed to buy and sell fund shares after the market closed while still getting that day’s price. This allowed Canary to profit from late news that was likely to push the price up or down the next day. As Spitzer said, it was like betting on a horse after the race was run.
The second offense, market timing, involves quick in and out trades to profit from market-moving news or events. Most fund companies officially discourage the practice, which pushes up the costs they incur to administer accounts and to buy and sell securities to create and retire fund shares. Some funds don’t permit investors to sell shares until they have been held a certain number of weeks or months. Others charge a special fee designed to make short-term trades unprofitable.
Late trading and market timing are both meant to exploit “stale” securities prices at the expense of the fund’s other investors, Musto says. The clearest example involves a fund holding foreign stocks traded on an Asian exchange that closes half a day ahead of New York. If Hong Kong stocks close sharply up, those prices won’t be used to figure the fund’s price until a day later. The late trader or market timer will thus get the day-old price, and can immediately sell at a profit after the fund’s new price is set the next day. That trader’s profits reduce the fund’s assets, cutting the value of the other investors’ holdings.
In addition to international-stock funds, funds holding small-company stocks and junk bonds are especially susceptible to stale-price strategies because their assets tend to be traded infrequently, Musto says.
The Cost to Ordinary Investors
A 1999 study by Roger M. Edelen, former finance professor at Wharton, and two co-authors entitled, The Wildcard Option in Transacting Mutual Fund Shares, concluded that traders could make sizable profits by exploiting stale prices. “We argue that the mutual fund wildcard option is of great concern to mutual funds and their investors,” the authors write. “The wildcard option involves the transfer of wealth to those that exercise wildcard options from the rest of the mutual fund’s investors.”
Eric Zitzewitz, professor of strategic management at Stanford Graduate School of Business, concludes in a recent study that late trading is widespread, occurring in one out of six fund families and costing investors $400 million a year since 2001. In a 2002 study, he concluded that market timing cost investors about $4 billion a year.
The Investment Company Institute, the fund industry’s trade group, has questioned Zitzewitz’s methodology, and there currently is no consensus on how much market timing and late trading are costing ordinary investors. Nor is it clear that many fund companies are willing participants even if stale-price strategies are widely practiced.
Musto notes that many fund investors buy and sell through brokerages. At the end of each trading day, the brokerage tallies the trades in each fund and then sends a net buy or sell order to the fund complex sometime after 4 p.m., trading the shares in the brokerage’s name. If the brokerage allows some investors to place orders late or to move in and out of a fund more often than the fund permits, the fund company won’t necessarily know about it.
By eroding assets, stale-price strategies undermine fund performance, Musto says. Fund companies thus have good reason to discourage it. Brokerages, on the other hand, have good reason to keep customers happy, and if some want late-trading and market-timing privileges, they will get it.
“I think, ultimately, people are always going to be doing things for their favorite customers,” Musto adds. In the Canary case, Bank of America, which is both a brokerage and fund company, had a financial incentive to bend the rules for the hedge fund.
Bogle argues this is just one example of the fund-industry conflicts that undermine investor’s interests.
Fund complexes and the companies that manage funds as contractors make money from fees charged directly to investors or deducted from fund assets. “The more the management company gets, the less the investor gets,” Bogle says.
While he believes better disclosure of fund fees can help reduce the problem, he feels regulators should strengthen rules governing fund directors. Typically, each fund family has one board of directors who oversees all the company’s funds. As a practical matter, the directors are picked by the fund company’s management, and a top manager is usually chairman of the board.
At the largest fund companies, median compensation for directors is $113,000 a year, according to a recent study by the consulting firm Mutual Fund Governance. Bogle says it’s not uncommon for directors to make more than $200,000.
Although a majority of directors must be outsiders, Bogle argues that rules be amended to require that the board’s chairman be an outsider. “I think the problem with the system is that the management company is the source of all information,” he says, suggesting that boards should have staffs of their own to help oversee fund managers.
Wharton finance and economics professor Franklin Allen, a director of the Glenmede fund family, says fund directors already realize they must improve fund governance. “There definitely is a sense that we have to move forward. I think the whole issue of conflict of interest is something we are going to be taking a very close look at.”
Fraud Harder in Fund Industry
Despite recent media coverage of fund problems, there’s little evidence investors have been severely damaged by fraud. Even if investors do lose $4 billion a year to market timing, as Zitzewitz contends, that’s a drop in the bucket for an industry that has more than $6 trillion under management.
Bond argues that major fraud is much more difficult in the fund industry than in ordinary corporations. Funds’ assets are easily audited, and performance is a simple matter of tallying the change in asset values. There just isn’t room for the kind of accounting shenanigans and inflated claims found in other big business scandals of the past few years.
Those scandals grew out of conditions that don’t really exist in the fund industry, he says. “What strikes me about this recent wave of corporate scandals is that we have been through this period of time where the benefits of lying a little bit were very large.”
Corporate executives sitting on huge blocks of stock options could make fortunes with little lies that pushed stock prices up, even if only modestly. And it was easy to nudge prices up during the bubble years when investors were so eager to act on good news.
“In contrast to some of these other industries,” Bond notes, “it’s relatively hard for a mutual fund to squander large amounts of investors’ money.”