A Black Eye for the Fund Industry

Earlier this year at the Investment Company Institute's annual convention, ICI Chairman Paul Haaga expressed amazement at the calls for increased regulation of mutual funds. He said, "It makes me wonder what life would be like if we'd actually done something wrong." Well, wonder no more.

New York Attorney General Eliot Spitzer leveled some very serious charges against some big names in the fund industry this week. The shocking part is that Bank of America's Nations Funds unit is accused of allowing a hedge fund to buy their funds at net asset value (NAV) set at the market's close up to four hours after the close. If true, this "late trading" was pretty much a license to take money from fund investors and give it to hedge fund investors.

Here's how the alleged arrangement worked. Say that a tech bellwether announces better-than-expected earnings after the U.S. markets have stopped trading. The hedge fund could then buy tech-heavy funds at the market-closing price, assured that technology stocks would rally the next day. This hurts fund investors because the fund manager would hold that hot money as cash, thus diluting the fund's participation in a rally.

That something like this could happen at a big money manager is amazing. It's an article of faith for fund investors that everyone is treated equally, yet that's not what happened here if the charges are true. If they are true, then this scandal ranks up there with Heartland's muni funds and Piper Jaffrey's mortgage funds, yet it happened at a much larger firm. For the gory details, check out Spitzer's complaint.

The second part of the complaint alleges that Janus, Strong, and Banc One allowed market-timers to buy their funds during the trading day for a quick profit. It's not a big surprise that timing was going on, but it is disturbing that fund companies would actually encourage the practice. Some firms, such as Vanguard and Fidelity, have slammed the door on market-timers with a variety of tools, but others have winked at them because they want to collect the fees that extra assets bring. While this is more of a gray area legally, it's still not appropriate to knowingly allow market-timers to make profits at the expense of long-term investors.

Here's how these kind of trades can hurt long-term investors while benefitting market-timing. The basic idea is to make an arbitrage play that takes advantage of the difference between the NAV at the end of the day and the information that's available. For example, European and Asian markets close well before the U.S., yet fund companies allow investors to buy in at the day's ending NAV all the way up the U.S. close. If U.S. stocks rally sharply in the afternoon, it's a very good bet that European and Asian stocks will follow suit the next day. Thus, their ending prices for that day don't reflect the rally that's sure to come. An arbitrageur can exploit that difference by purchasing a U.S. fund in the interval between Europe's close and the U.S. market's 4:00 p.m. (Eastern) close. This hurts long-term investors because, as in the example above, it drives up the fund's cash position so that their participation in the rally is diluted.

A few years ago, the Securities and Exchange Commission encouraged fund companies to practice fair value pricing in order to fend off the market-timers. Fair value pricing means that a company uses a matrix of indicators to adjust prices of their foreign holdings to reflect any changes in the U.S. market. For example, if a foreign fund was half financials and half pharmaceuticals, the fund company could adjust the fund's closing NAV to reflect any changes to U.S. financials and pharmaceuticals indexes on the assumption that foreign stocks will move in sync with their industries. While this practice was encouraged, it wasn't required and no set methodology was required.

To a lesser extent, similar arbitrage moves are possible with funds that hold U.S. securities that are less liquid. Small caps and junk bonds don't instantly reflect news the way more liquid stocks and bonds do, so an arbitrageur who waits until the last minute can make some good trades if the fund company lets them do it.

Fair value pricing isn't the only weapon that fund companies have to stop market-timers. Putnam and Vanguard instituted redemption fees in their international funds that apply to short-term trades. Schwab does something for all the funds traded in its supermarket. In addition, fund companies have systems that let them flag accounts that move in and out of their funds, and they regularly shut these accounts down.

What is surprising about the firms that are accused of letting market-timers have their way is that the e-mail evidence Spitzer released indicates they coldly decided to allow it, calculating how much it would boost their bottom lines even though they knew it would hurt long-term fund shareholders.

A Few Ideas to Avoid More Messes Like This
The Securities and Exchange Commission appears set to pursue some much-needed improvements in fund regulation. Rep. Richard Baker, chairman of the House Subcommittee on Capital Markets, and the SEC proposed several rules in June advocating greater disclosure on fund manager incentives and mutual fund fees and suggesting that it may take a more active role in assuring that fund directors are independent. The Baker bill has some important ideas that would boost oversight of funds by investors and regulators alike.

In addition, these problems are another sign that we need fund directors with spines. Long-term investors with large stakes in the funds should sit on boards. Directors should be limited to serving on only a handful of funds so that they can provide the oversight that's needed. In addition, directors should be paid in shares and required to hold them for at least five years.

More generally, though, the industry should heed Jack Bogle's call to return to their roles as acting as long-term stewards of investors' money rather than short-term fee maximizers. Character counts, and the industry needs more of it.

As investors in mutual funds, we can do our part by simply seeking out those firms that put fund investors' long-term interests ahead of everything else. Rather than chasing performance, investors should seek out managers with large sums of money in their funds who treat other fund investors like owners rather than rubes.