At the height of the insider-trading scandal in the 1980s, Congress tightened the restrictions against abuses by investment insiders. A 1988 law imposed harsh penalties on any securities firm that failed to monitor adequately the trading practices of its employees. For the most part, the law has worked well. So it is disturbing that a new source of worry has arisen--this time from the comparatively scandal-free mutual-fund industry.
A recent flurry of bad publicity about fund managers trading for their own accounts gives investors some cause for concern. On Jan. 4, Invesco Funds Group Inc. abruptly fired its star portfolio manager, John J. Kaweske, alleging that he had failed to report his personal investments properly. (Kaweske denies any wrongdoing.) Investors at other fund groups have no way of knowing whether their fund managers are violating the rules--or even what those rules might be. It's a common practice for fund managers to trade for their own accounts. But the ethical codes that regulate such trading vary widely, and there are vast gray areas that allow fund managers to profit from their positions as insiders.
Concealing personal trades, as has been alleged at Invesco, would be a firing offense at any company. An even more serious offense would be "front-running," in which managers buy stock for themselves and then buy the same shares for the fund. But there is a wide range of other dubious trading practices, and what is a firing offense at one company can be standard practice at another. Consider these differences in trading policies:
--At Smith Barney Shearson Inc., mutual-fund managers and brokers are barred from making a short-term profit on personal investments: They can't buy and sell the same stock within a two-month period. But many other firms impose no such restriction.
--Some fund companies allow managers to invest personally in private placements. If the companies go public, the managers may put their mutual funds into those same companies. Other firms consider this a conflict of interest because the fund investment invariably boosts the share price and enriches the fund manager.
--Some companies either allow employees to serve as directors of companies in which they invest privately, or else they wink at the practice. Kaweske, for example, was the director of ID Biomedical Corp., a company in which he both owned a personal stake and had invested for his funds. Invesco claims the firm never knew. Kaweske's lawyer, however, maintains it was common knowledge.
The rules are unclear in many other areas. At mammoth Fidelity Investments, former fund managers say, managers have been known to identify stocks that other managers were about to buy for their funds, and then buy the stocks for their own account. Another technique cited by an ex-Fidelity manager was to short the stocks that were bought by managers they don't respect.
The issue is not whether personal trading by fund managers should be banned. There's a strong argument in favor of permitting such trades, because investment professionals should be allowed to make money legitimate-
ly just like anyone else. Such trading also can sharpen their investment skills, thus ultimately benefiting fund customers.
The issue is one of public disclosure. Investors are clueless when it comes to what rules the people who manage their money are supposed to follow for their own trading. The Fidelity and Merrill Lynch fund groups, for example, won't disclose the terms of their ethics policies--thereby leaving their customers in the dark about the rules followed by their fund managers. Fund companies would help their cause if they included in their prospectuses a detailed description of the rules governing trading by the fund's own employees.
THIN BLUE LINE. More oversight is also warranted. Fund companies boast of their clean records--especially when compared with brokerage firms--but they shouldn't be too cocky, as Invesco shows. The Securities & Exchange Commission has been complaining for years that it has too few resources to monitor fund companies. And it's right: 46 examiners are not enough to regulate an industry with $2 trillion in assets.
There are now two proposals in Washington to strengthen regulatory oversight. Legislation in Congress would boost fees paid by fund companies to the SEC to allow the agency to hire more examiners. The other idea, floated by SEC Chairman Arthur Levitt Jr., is to use fund fees to create a self-regulating body for the industry, similar to the one used by the New York Stock Exchange. Both make a lot of sense. But the fund companies would do well to seize the initiative while Washington dithers. Publicizing fund conflict-of-interest rules would go a long way toward easing investor fears and preventing an ill-advised crackdown on a dynamic industry.