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Why the Mutual Fund Trading Scandal Still Matters Today

Two decades later, we share lessons learned from this regulatory imbroglio.


Twenty years ago, then Attorney General of New York Eliot Spitzer fired what would be the opening salvo of one of the most shocking scandals to ever befall the world of mutual funds. On Sept. 3, 2003, Spitzer accused New Jersey hedge fund Canary Capital Partners of engaging in unsavory trading practices with several mutual fund providers and brokerage houses. Spitzer’s first lawsuit embroiled Canary and Bank of America’s then-named Nations Funds, but he alleged the hedge fund had cut deals with other fund families and financial firms to profit at the expense of buy-and-hold mutual fund investors. Canary’s name proved unintentionally and ironically apt, for the charges against it were the first wafts of a mushrooming noxious fiasco for the industry.

The scandal spread quickly from there. Spitzer levied more charges against other fund complexes, and the SEC and Massachusetts Secretary of State William Galvin piled on. Several company executives resigned, more than one firm put itself up for sale by the end of 2003 alone, and over the next few years, the scandal ensnared more fund firms and executives. Fund families all together paid billions in penalties and disgorgement of ill-gotten gains; regulators demanded more oversight; fund managers and executives lost their jobs; entire brand names disappeared.

For all these facts, arguably the mutual fund trading scandal doesn’t receive the same recognition today that other widespread crises like the 2008 global financial crisis and the 2000 dot-com bust. This scandal is worth revisiting, though, as the modern investor, especially one who was not an active investor during the era, can glean some valuable lessons about what can happen in even highly regulated financial services industries.

The Scandal and its Discontents

What is known as the mutual fund trading scandal involved a couple of arcane practices that enabled short-term traders to profit at the expense of long-term investors. The first was “late trading,” in which mutual fund families, like Nations Funds, allowed hedge funds, like Canary, and other insiders to buy their funds well after the market close at the fund’s day-end net asset value. The other was “market timing,” the practice in which fund companies allowed certain traders the ability to buy and sell their funds much more quickly than their prospectuses allowed, usually with the aim of profiting off markets with lags in pricing data like international or small-cap equities.

Although Nations Funds and Canary were at the center of Spitzer’s original complaint for late trading, Spitzer accused three other fund families of engaging in market timing: Janus, Strong Funds, and Bank One. By the end of the year, several other players found themselves drawn into the controversy: AllianceBernstein, Invesco (including both AIM-branded and Invesco-branded funds), Federated Investors, Alger, PBHG, MFS, Fremont, and Putnam received varying levels of condemnation from regulators, and they met these summonses with varied degrees of contrition (or even defiance). Several of these names were midsize or even small boutiques in their era, but Putnam saw a particular level of scrutiny given it was one of the largest U.S. asset managers at the turn of the millennium.

Several major fund companies, including American Funds, Vanguard, and Fidelity, avoided the controversy. Then still-nascent exchange-traded funds also dodged the mess because, although their structure allowed investors to trade them throughout the day, the vehicle also buffered long-term ETF holders from the buying and selling of more-frenetic traders. The scandal spelled the end of some firms, like Strong and PBHG, while others, like Janus and Putnam, managed to survive but haven’t regained their pre-scandal and pre-tech-bubble-crash zeniths. At least one implicated firm, MFS, emerged from the crisis stronger.

Takeaways from the Trading Scandal

The scandal exposed which firms were willing to compromise fundholders’ long-term interests. Other takeaways included:

Follow Your Own Rules: Several of the fund companies that paid massive fines or fired portfolio managers and executives prohibited rapid trading in their prospectuses. Many firms also had trading desks whose duties comprised looking out for and stopping frequent trading in their funds. It may seem obvious, but investors should be able to assume that if a fund family says it discourages market timing in its prospectuses, that it will not encourage it.

Transparency Matters: Some useful new regulations came out of the mutual fund trading scandal era. In addition to introducing reforms that made mutual fund pricing and operations more transparent, the SEC strengthened rules around late trading and required additional disclosures and redemption fees to address market timing. In 2004, the SEC also required listed portfolio managers to disclose how much they invested in the funds they ran in broad bands on at least an annual basis. This helped reveal which managers were paying the same expenses and experiencing the same returns as fundholders. Morningstar has long found that funds with high levels of manager investment are more likely to succeed over time.

Stewardship Matters: There’s more to choosing a fund than finding a good manager with a sound process. Several of the implicated funds had received glowing reviews of their teams and approaches. Many of their parent firms, however, tended to focus more on salesmanship than stewardship; they were more apt to roll out trendy, risky funds, or advertise recent performance, for instance. Malfeasance at one or two funds in a family can cast a pall over the whole complex and put innocent funds at risk of outflows, distractions, and personnel turnover. It’s no coincidence that Morningstar started publishing the first iterations of our parent ratings—formerly known as stewardship grades—shortly after the scandal.

Caveat Emptor

The odds of another mutual fund trading scandal happening are low, but other scandals have happened and will happen. It doesn’t take an indictment or expose on the front page of The Wall Street Journal for stewardship to matter. Asset managers that do not chase trends, do not charge unreasonable fees, do not boast about short-term performance, do not stress asset gathering over performance, do not equivocate or obfuscate in shareholder communications, or do not shun investing in their strategies are more likely to give investors good experiences. The tools of the trade are different, but human nature remains the same: Investors still need to be careful with whom they entrust their hard-earned dollars.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Gabriel Denis

Senior Analyst
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Gabriel Denis is a senior manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

Denis assists with parent research and is a member of the global parent ratings committee, which oversees the assignment of Morningstar Parent Pillar ratings for all investment managers under coverage. Additionally, he helps coordinate environmental, social, and governance research and is a member of the ESG Commitment Level ratings committee.

Prior to his current role at Morningstar, Denis focused on fixed-income strategies and published research on sustainable bond strategies and broad taxable fixed-income market trends. Before joining Morningstar in 2016, Denis served with AmeriCorps Vista in Baltimore.

Denis holds a bachelor's degree in history from Johns Hopkins University.

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