Fraud in Mutual Funds
Dr. Neville Bennett
November 12, 2003
The greatest scandal in the history of the mutual fund industry has sent the American saving market reeling. A quarter
of the nation’s broker-dealers engaged in illegal late trading. Half of the biggest mutual funds let certain
shareholders engage in "market timing" deals that are banned in their prospectuses. 30% of fund manger admitted they
gave sensitive portfolio information to privileged individuals.
This provides new evidence that the culture in the industry needs fundamental remedial behaviour modification. Managers
ignore clear rules when profitable opportunities arise.
The core of the latest scandal broke some weeks ago (NBR September12) when Canary Capital Partners, a hedge fund, was
permitted by Janus Funds to trade its shares after the closing bell, and when it knew by international activity, that
the fund was a "buy" or "sell" ("late trading’).
Another practice is called "market timing" or "international fund arbitrage". Here is how it works. A fund announces its
price at 4 o’clock in New York. Before the next morning, there are trades in international markets, and "timers’ are
permitted to buy into the fund the next morning at the previous day’s price. It is money for jam. Managers do not always
mind it because they get activity fees and greater turnover. While some funds have "police’ who watch for big, give-away
trades, Spitzer says ‘dozens" of funds condone timing even though their prospectuses say timing is not permitted.
Another allegation is that funds provided an up-to-the-minute record of their portfolio to hedge funds. Investors get
told very infrequently what they have shares in. Hedge funds know immediately and this improves their trading
opportunities.
This malfeasance is being investigated simultaneously by a lot of heavy hitters. As 95 million Americans hold mutual
funds, the issue is paramount in politics. Both the Senate and House are holding inquiries. So are the Securities and
Exchange Commission, and the State of Massachusetts. Earl Spitzer seems to be testifying at all the hearings.
Spitzer seems to be raising the heat by going beyond management to the board level. He believes boards condoned
conflicts of interest in order to increase fee income. "The governing structure has failed’, he pronounces, and demands
that chairmen have no contact with management or advisory boards.
Meanwhile the scandal has claimed some big names. Richard Strong has resigned as chair of Strong Mutual Funds. Strong
has US$47 billion under management, and said that it would not engage in market timing. Its Chair and CEO did. Strong
says he did it for his family and a few friends. One trusts that these favoured individuals will visit Mr. Strong in the
penitentiary, should that be his place of destiny. Spitzer will file criminal charges this week.
Spitzer has a good track record. Last year he spearheaded a ground-breaking investigation into Wall Street securities
firms which resulted in a US$1.4 billion settlement aimed at cleaning up research. Spitzer found that some Wall Street
firms were recommending firms because of broker’s vested interests. Citigroup for example was obliged to separate its
research and brokerage houses.
The biggest casualty is Putnam’s. Putnam’s was the fifth biggest mutual fund with US$272 billion under management. It is
alleged that some managers allowed late and market timing. The market has savaged it. State pension funds of
Massachusetts, Rhode Island, Iowa and many teachers’ pension funds have been withdrawn. The CEO has stepped down, but
many observers feel that Putnam cannot recover. So far, it is the only firm facing criminal and civil law charges.
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- Dr. Neville Bennett
Christchurch, New Zealand
n.bennett@hist.canterbury.ac.nz