From “Ripped Off” to a “Better Deal” – How Investors Fared Since the Market-Timing Scandal

In today’s episode, Russ Kinnel, director of manager research for Morningstar Research Services, talks about the 2003 mutual fund scandal that resulted in allegations of market-timing and late trading. He also discusses increased transparency and lessons for investors.

Timestamps:

00:44 Will Investors Try Birkenstock on For Size?

02:04 NVIDIA’s Sky-High Performance

03:32 Mutual Fund Scandal’s 20th Anniversary

22:19 5 Stocks to Sell Before Labor Day

Read about topics from this episode.

Birkenstock IPO: Will Investors Find the Price Uncomfortable?

After Nvidia Stock’s Huge Rally, 6 Key Things to Watch in Q2 Earnings

After Earnings, Is Nvidia Stock a Buy, a Sell, or Fairly Valued?

The 5 Biggest Mutual Fund Rating Upgrades of 2023

3 High-Dividend Stocks to Avoid

5 Stocks To Buy as Q2 Earnings Season Wraps Up

What to watch from Morningstar.

Economy Outshines ‘Uneventful Earnings'

Microsoft Bets Big on AI: What Investors Should Know, Part Two

Microsoft Bets Big on AI: What Investors Should Know, Part One

Interest-Rate Forecast: What’s Next?

Read what our team is writing:

Ivanna Hampton

Russel Kinnel

David Sekera

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Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. A close-up at five pricey stocks that you may want to sell right away. Birkenstock made a fashionable cameo in the Barbie movie. Coming up – the move it’s reportedly planning in hopes of winning over investors. And – a trading scandal rattled the mutual fund industry 20 years ago. Morningstar Research Services’ director of manager research Russ Kinnel will explain how the aftermath strengthened investor protection. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Birkenstock is preparing for its initial public offering. But will investors try it on for size? The company is known for its hip and comfy footwear. Private equity firm L. Catterton owns it, and Moet Hennessy Louis Vuitton backs it. L. Catterton bought the 250-year-old company a couple of years ago from members of the founding family. Data from Morningstar’s venture capital unit, Pitchbook, shows the deal was worth almost $5 billion. The new owners are looking to cash out. Goldman Sachs and JPMorgan reportedly value the company at more than $8 billion for the IPO. Morningstar Research Services’ senior equity analyst Jelena Sokolova says that despite strong growth for the brand and its prime placement in the new Barbie film that valuation may be a bit ambitious. Birkenstock reported earnings of about $414 million in 2023, more than double its take in 2020. Some of that success was due to a robust sales campaign in the United States and Asia. That included its Barbie movie appearance. The company is also investing big and fast-tracking a new plant in Eastern Germany. Birkenstock will be listed on the New York Stock Exchange rather than in Europe, in hopes of getting a higher valuation.

The artificial intelligence craze is fueling Nvidia’s sky-high performance. The chipmaker’s total revenue came in at $13.5 billion in the July quarter, surpassing its own $11 billion forecast. Its fiscal second-quarter results exceeded Morningstar and Wall Street’s expectations. The company has raised its outlook. Morningstar believes Nvidia’s data center business will bring in $41 billion in revenue in fiscal 2024. That’s almost three times more than a year ago. Nvidia's results, outlook, and expansion at suppliers like Taiwan Semiconductor Manufacturing are driving this prediction. Morningstar anticipates further growth in data center revenue and estimates it could soar to $100 billion in fiscal 2028. While this kind of growth may be unprecedented in large-cap tech, Morningstar foresees all types of enterprises investing in AI. All cloud providers will also need to offer Nvidia’s advanced chips to allow them to train AI models. Nvidia is taking the right steps to capture AI inference workloads and branch out into networking and software. Morningstar is raising its estimate for what Nvidia's shares are worth from $300 to $480. A wide range of outcomes is possible with the stock.

A scandal rocked the mutual fund industry 20 years ago. It also reshaped the relationship between fund companies and investors. Morningstar analysts watched it unfold, wrote about it, and went to Capitol Hill to recommend changes. Morningstar Research Services’ director of manager research Russ Kinnel was one of those voices calling for investor protection.

Ivanna Hampton: Thanks for joining me, Russ.

Russel Kinnel: Glad to be here.

Hampton: So, in 2003 then New York Attorney General Eliot Spitzer, revealed he was investigating mutual fund companies for practices hurting small investors. What did he find?

Kinnel: Well, one of the initial things he found was market-timing, which means funds officially were saying that you couldn't rapidly trade inside of 90 days, but they're letting special clients trade in and out quickly, in exchange for the clients putting dedicated money, say, in their money market funds.

So essentially, they collect fees over here, but they are letting funds make these rapid trades, or someone else make these rapid trades. And by doing that, they're essentially offloading some of the costs onto the fund investors. So, they were avoiding commissions and other things, capturing some of the gains and putting some of the costs on the long-term investors.

Hampton: You were working at Morningstar at the time. When you heard this news, what did you think?

Kinnel: I was really surprised. It was an industry that was largely scandal-free, and we knew enough to know that it was not a pure industry that was without fault, but it was a surprise. And one of the elements that was surprising was this wasn't the SEC bringing the case, this was the New York Attorney General. And these were open cases, often SEC actions. They're announced at the same time as a settlement. So, "We found this, and this was the fine, and these are the remedial actions they have to take."

But this was just Eliot Spitzer saying, "We found these bad things at these fund companies, and nothing's been settled, nothing's been proven.” And so, it was a really unusual course of events.

Hampton: Let's get into the allegations. You mentioned market-timing. It's not illegal. Can you explain how some funds were able to pull this off and how it violated investors?

Kinnel: A lot of fund prospectuses said, we can prevent you from rapidly trading, say, within 30 days or 90 days, or it might be you're limited to six trades, and something like that in the prospectus. So essentially, it's, are you violating your prospectus? The funds believed that meant that was an option for them. In other words, they had the right to bar you. It didn't mean they were explicitly barring you from trading. Eliot Spitzer said, "Oh no, that's a promise that you're promising to fund investors—you'll keep these short-termers out." And so, it was this kind of gray area, really nothing had been officially settled. But he said, "No, you're violating the prospectus."

And so, what was happening was in the wake of the bear market, which was 2000-02, fund salespeople were desperate to bring in new money. And they were willing to accept these market-timing offers from—it was hedge funds and others looking to make a fast trade. And so, let's say they wanted to trade in and out of a small growth fund within a day, and there aren't a lot of futures and there weren't a lot of ETFs then to make that easy to do, so they could do this. And then there are commissions and other trading costs involved, all of those would be spread out over all the investors, and they would get in and out and make their quick profit.

It's kind of an arcane aspect, but nonetheless it does cause some harm, but it's on the level of a few basis points for investors. So, it's in the misdemeanor camp and very much in the gray area.

Hampton: Market-timing is not illegal, but late trading is. Can you describe what makes it a crime and how it's carried out?

Kinnel: Yeah. A fundamental way of the way funds works is that funds declare an NAV every day. That's kind of the guts of the way funds work, is they have to declare a net asset value. They have to value their portfolio every day. And if you buy in before the New York Stock Exchange closes, you get that NAV. So, the market closes at 3:00 Central and then about 5:00 they post that NAV, but you can't trade between 3:00 and 5:00.

However, there were some cases where ... And the fund companies were largely on the honor system with the brokers putting those orders in. And so, they're supposed to have systems, but the fund companies up until then were largely taking it at their word that they were not allowing any trades after 3:00. So, if you were allowed to trade after 3:00 then, say, there was market-moving information, maybe two tech companies report big earnings at 3:15 or there's some other world event, oil prices go up or something like that, then if you could make that trade, then you're essentially getting free money, because getting 3:00 prices but you're getting something after that.

So, these were much more isolated than the market-timing, but there were some cases of that, and that's clearly illegal. And in the wake of that, fund companies would go on to make a much cleaner trail, electronic trail for all those trades, so as to make sure that no one could do that again.

Hampton: What were some of the worst behaviors to come out of this scandal?

Kinnel: As I said, the market-timing is kind of a misdemeanor, but all of the scrutiny came out and it found a lot of worse practices, and it highlighted the fact that maybe the SEC wasn't focusing enough on mutual funds at the time.

So yeah, there were some really bad things. One of the worst ones was, at PBHG some fund managers, who had also invested in hedge funds, were tipping off the hedge funds to the trades they were going to make in the mutual funds. And these were momentum-driven funds, so momentum trading tends to really move stocks. If you're going to buy these three hot tech stocks and a couple of biotech stocks, that might move the trade up. So, they would tip off the hedge funds, hedge funds would buy, and then they'd buy in the mutual funds. And of course, that meant that the mutual fund investors were getting ripped off because they were paying the higher prices, and so they were having diminished returns. So that was one of the worst ones.

We saw some managers at Putnam who were exploiting fair value pricing issues. Which, essentially, a foreign fund is investing in a lot of markets, and Japan and Asia and Europe are each closing before the U.S., but you're still striking that 5:00 PM net asset value. If you use the closing prices from Japan and you use the closing prices in Europe, you're using much earlier prices. And again, let's say after those markets close, there's some market-moving information and the fund company isn't adjusting prices, then again, let's say there was some good news that comes out, if the fund doesn't do that, it doesn't make any price adjustment. Then that means it's going to have an artificially low net asset value for that day, and then it's going to have sort of an automatic pop.

So, these fund managers, in their own funds, were buying if they knew that there was going to be that pop the next day. And of course, the solution is fair value pricing, which means you adjust. So, let's say you've got some healthcare stocks in Europe and healthcare rallies after Europe closes, then you say, "OK, healthcare stocks rallied 2% here. We're going to adjust those prices up 2%." And after the scandal that became the norm. Before then, some fund companies were doing it, some weren't. But obviously, as a fiduciary, a manager should have said, "Hey, this isn't a great system. We should fix that." And at a bare minimum, they certainly shouldn't have been exploiting it. So that was another one.

Another issue we saw was Dick Strong, head of Strong Funds, was making these small trades, and they were market-timing trades, where he would do, say, small caps sometimes have a lag, and they go up after large caps rally. So, he was making quick trades into the small caps. And their compliance officer knocked on his door and said, "Hey, you're breaking our rules for rapid trading." He said, "It's my fund company, I'll do what I want." And again, that was only market-timing, but from the CEO of the darn fund company it's kind of appalling. So yeah, some much worse stuff did come out.

Hampton: What was it like for Morningstar analysts to cover firms at this time?

Kinnel: It was really stressful. We'd always been in a position where we would criticize bad practices, and not everyone loved us for that, but it was much less adversarial. All of a sudden we had to come out with these recommendations. And I mentioned that a lot of these cases were announced and came public before there was a settlement. And when there's a settlement, you've got the remediation and you also have, say, the SEC or whoever might say, "OK, and these three people have to leave the industry." But this was all in a fluid state, so in some instances we'd say, "There are major questions about this firm's ethics and policies, so you might want to consider selling," or we might say, "You might not want to commit new money." And we were saying that about the whole fund company, not just one fund. So that put us in a much more adversarial position.

But over time, I think we actually came out in a better relationship with a lot of fund companies because we would go out and visit them, we would go through all the details, we would get to know them, and they saw at least we were putting in the work. And eventually we would change our recommendation as they addressed their various problems. But yeah, it was very stressful to be in the middle of that fight.

Hampton: I can imagine. Morningstar's Managing Director Don Phillips, he testified before Congress in 2003 and he said, "Rather than being at the top of the pyramid, fund investors today find themselves at the bottom of the food chain." Russ, does that still hold true 20 years later?

Kinnel: No, I don't think so. I think the fund industry has improved a lot. If you look at where the money has flowed over that time, it's to lower cost, better run funds. Fund companies really got religion in a hurry. And I think it's not that the industry is perfect, we still have trendy ETF launches. AI's hot, all of a sudden there's going to be 10 hot AI ETFs, and that's not a great thing for investors.

But I think investors do have a better deal. Money is in cheaper funds. If you look at most of the big fund companies today, they're much more ethical than the big fund companies 20 years ago. So, we've had a natural selection, and so I think fund investors have a better deal. ETFs have given them a lot of low-cost passive options. And in traditional open-end fees are down, and there's a lot of really good options there. So, I feel like investors by and large are in a better quality of funds. They're in cheaper funds, so things have improved significantly.

Hampton: And you mentioned that investors are in cheaper funds and in ETFs. Were there any other places where they took their money if their confidence was rocked by the mutual fund industry?

Kinnel: Well, certainly a lot of it went from active funds to passive, and that sort of started back then, but also really gained steam with the following bear market in '08 and '09. But yeah, I think some investors were turned off from funds and may have chosen to invest in individual stocks, but certainly a lot of money at that time moved to the fund companies that came out of it clean. Money moved to Vanguard, money moved to Fidelity, money moved to American Funds. Those were probably the biggest beneficiaries. Dodge & Cox was a beneficiary as well.

But those were firms that not only were clean in the scandal, but also again, we were coming off the bear market. And some of the firms like Putnam and Janus that got caught up in the scandal also burned people in the bear market. And so, sort of a combined effect—if you did a good job for investors in the bear market and you came out clean from the scandal, the money really flowed there.

Hampton: So, investors were definitely watching.

Kinnel: They certainly were.

Hampton: Morningstar created its Stewardship Rating, now it's called the Parent Rating, in the aftermath. How does it help investors?

Kinnel: We really try and reflect the firm's culture, their values, their people, and their incentives. On an individual fund level, you tend to focus on the particular manager and analysts and strategy there, but the Parent is a way of pulling all that together. And we look at things like I mentioned before, do they launch trendy funds? Do they keep fees low? Do they do other shareholder-friendly activities? And so, it really reflects all of that.

And if you are investing in a fund for the long term, that Parent becomes more important. Over the next year or two it might be just that manager and the strategy, but over time analysts will change, managers will change, and there'll be a lot of key decisions that are Parent level. Do they have a good investing culture? Do they have lots of good managers and analysts because they have good incentives? The fund companies that have all their ownership within the investment professionals and others at the firm, they tend to have much more stable transitions because they have good incentives for people to stay there. They don't have an incentive to sell out to someone who's just going to cash in on those mutual funds.

It really helps to, I think, ground the Medalist Ratings, but also give everyone a good picture of what's going on at the fund company. And we go out and visit the fund companies, and we talk to a lot of people we don't normally talk to, besides the managers. So, we talk to salespeople and traders and people who are responsible for compliance and get a much more complete picture of a fund company.

Hampton: Talk about how the rules that came out of this scandal reshaped the mutual fund industry.

Kinnel: Some rules came and went, like there were limitations on trading and other things that came and went with simply better tracking. But there are other things like better compliance-officer functions. There are manager investment disclosures, one thing that came out about a year later. Before managers could say they invested in the fund, but they didn't have to prove it. Then the SEC said, "OK, you've got to report in these bands." So, I think that's a really good tell.

When it was first required, we'd find some fund companies' managers didn't really invest anything in their funds, which really revealed that they didn't really believe in it, and they've gotten better at that. So, I think there are some different rules. And at the same time, ETFs have brought greater transparency. It's not a regulation change as a result of the scandal, but ETFs are more transparent, and that's clearly another way that investors have benefited. As they say, "I love the transparency of these ETFs. I can see what I own. And if I own a passive fund, I know exactly what I'm going to get." So, there's just greater transparency in the industry, in general.

Hampton: What do you think the lesson is from this scandal?

Kinnel: I think it matters who you invest with. If you focus too much on, these are good returns, or that you're missing a lot, there's a human element, ethics matter, culture matters. So, it helps to step back and look at the firm you're investing with and not just think about that individual fund.

And I think there are lessons obviously for the industry that remind people you're a fiduciary and take that duty seriously. You owe these investors your best effort, you can't cut corners. And so, I think there's lessons for both investors and fund industry people.

Hampton: What safeguard or two do you think investors should have, but don't?

Kinnel: Well, I think mutual funds could do a better job on the manager's disclosure. We have these bands, but they end at one million, and managers make a lot of money. It would be much better to just disclose the shares they own. If you own a company, you know the exact number of shares the CEO owns. If you own a closed-end fund you even know the number of shares they own, but you don't with a mutual fund. So that's one obvious thing, I think.

Continue movement to greater disclosure is good. Better incentives for the managers. So, there's still some things, but I think a lot of ways the industry is in a better place than it was 20 years ago.

Hampton: Well, thank you, Russ, for this walk down memory lane. Maybe we could do a 30th anniversary.

Kinnel: Yes, I'll be even older and grayer, and I might forget more, but it might work.

Hampton: It's something to look forward to.

Kinnel: Yes.

Hampton: Morningstar’s fair value estimate provides a snapshot of what a stock is worth in the long term. A company’s stock price can go above what analysts think it should – signaling shares are overvalued. Here’s Morningstar Research Services’ chief U.S. market strategist Dave Sekera with a list of five pricey stocks to sell.

Dave Sekera: Hi, I’m Dave Sekera, chief U.S. market strategist with Morningstar Research Services, filling in for Susan Dziubinski this week.

Half the battle in long-term investing is identifying high-quality companies whose stocks are trading at a significant margin of safety from their intrinsic value.

The other half of the battle is avoiding those stocks that are overvalued, or in today’s case, selling those stocks that have run up too far in price that they have become overvalued and overextended.

First up today is Hess. Hess is one of those situations in which it has some of the best assets, with great growth prospects, and deserves a high valuation—but in our view, the market valuation is just way too high as compared to our assessment of its net asset value.

For example, when we look at different valuation metrics in this case, such as enterprise value/EBITDA (where EBITDA is an approximation of free cash flow) the stock is trading at an EV/EBITDA of well over 9 times. Hess’ next-closest competitor is closer to 6 times. So our fair value actually places an EV/EBITDA at about 7 times, higher than its competitors, but still well below the current market valuation.

Technology stocks, of course, have just soared thus far this year and Oracle has not been left far behind. In fact, Oracle’s stock has surged over 40% this year to new all-time highs, and now trades at about a 50% premium to our valuation. This places the stock in 1-star territory. The company actually has posted very good performance, but our equity analyst has concerns that there is much more limited upside over the long term to the cloud infrastructure market than what the market is currently assuming.

Also in the technology sector is Cadence Design Systems. Fundamentally, Cadence is doing very well. It posted strong second-quarter results and, based on the elevated demand for hardware solutions, management even guided to a stronger second half of the year.

In our forecasts we already incorporate that secular trends toward artificial intelligence, 5G communications, and cloud computing will actually continue to accelerate, and that Cadence will benefit from both the rising intricacies of chip designs and the increasing complexity of various end markets. Yet even after incorporating the acceleration of these trends, the stock is now trading at about a 40% premium to our valuation, as it’s risen 40% thus far this year. As such the stock is currently rated 2 stars.

Next up is Old Dominion Freight Line. Old Dominion provides less-than-truckload carrier services. Its business has been under pressure as trucking companies are adversely affected by retailer destocking and a pullback among U.S. industrial end markets.

Yet Old Dominion’s stock has surged over 40% this year, with the preponderance of that gain coming in just the past two months. The reason for that surge is the market’s hope that Old Dominion will gain a significant amount of market share following the bankruptcy of its competitor Yellow Trucking. In our projections, we do forecast that it will gain a meaningful amount of those shipments, and we have boosted our short-term forecast for volume recovery. However, in our view, the market is overestimating the amount of long-term free cash flow growth.

Lastly is Eli Lilly. It’s been in the news a lot this year. Its type 2 diabetes drug, Mounjaro, has been found to help in weight loss.

In our forecasts, we already include an above-consensus projection for peak sales for this drug, yet in our view, the market is paying way too high a valuation for this growth. We rate the stock with 2 stars and it trades at about a 50% premium to our valuation.

For more stock ideas, please be sure to subscribe to Morningstar’s YouTube channel and visit Morningstar.com.

Hampton: Thanks Dave. Subscribe to Morningstar’s YouTube channel to see new videos from our team. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say ‘Play Morningstar’. Thanks to senior video producer Jake VanKersen. And thank you for tuning into “Investing Insights.” I’m Ivanna Hampton, a senior multimedia editor at Morningstar.