A Primer on the Mutual-Fund Scandal

A ready reckoner to help investors understand Eliot Spitzer's crusade against late trading and other abuses

By Amey Stone

When it comes to financial scandal, the mutual-fund industry had always seemed above the fray. No longer. On Sept. 3, New York Attorney General Eliot Spitzer kicked off an industrywide probe with allegations that four prominent fund outfits allowed a hedge fund to trade in and out of mutual funds in ways that benefited the parent companies at the expense of their long-term shareholders.

By Sept. 16, Spitzer's office and the Securities & Exchange Commission had filed criminal and civil charges against a former Bank of America (BAC ) broker who allegedly facilitated illegal trading in mutual funds. More fund companies are being subpoenaed for information about their trading, and more state and federal regulators are joining the growing investigation. It's all but certain that more fund firms will be drawn into the deepening scandal.

Yet this major crisis for the fund industry has failed to inspire much fury from investors, and it has done little to halt a rising stock market. Maybe a partial explanation is that the fund companies allegedly did wrong, and why it hurt shareholders, is difficult to understand. For anyone who has read widespread coverage of the topic but wanted to scream, "Explain what the heck is going on," we provide the following discussion:

Let's start at the beginning. How is a mutual fund set up?

A mutual fund is like any other public company. It has a board of directors and shareholders. Its business is investing -- in stocks, bonds, real estate, or other assets -- using whatever strategy is set out in its prospectus, with money from individual investors. Its strategy could be to buy, say, small, fast-growing U.S. companies or to purchase the debt of firms across Europe.

A fund's board hires a portfolio manager as well as an outside firm to market and distribute the fund to investors. But funds can become big quickly, and the larger ones operate a bit differently. A fund-management company (think Fidelity or Vanguard) sets up dozens of funds, markets them to investors, hires the portfolio managers, and handles the administrative duties. It makes a profit collecting fees (usually a percentage of assets under management) from the funds it manages.

A fund company typically has in place the same board of directors (including some independent members) for its funds. The board of directors should be on the lookout for abusive practices by the fund company, but directors often have too many funds to oversee and may be too aligned with the company's portfolio managers to provide much oversight.

This case concerns mutual-fund trading. Does it involve the portfolio managers?

No, that's not what this case is about. Portfolio managers buy and sell securities for their funds. But the alleged improper trading has to do with outside investors buying and selling a fund's shares. Spitzer's complaint actually concerns the activity of one firm, Canary Capital Partners, but he alleges the same activity is far more widespread.

Portfolio managers, who are usually compensated based on their funds' performance and frequently have their own money invested in their funds, are usually shareholders' greatest defenders against trading practices that hurt long-term results.

How are mutual funds traded?

Funds can be bought and sold all day. However, unlike stocks, which are priced throughout the trading day, mutual funds are only priced once a day, usually at 4 p.m. Eastern Time. At that point the funds' price, or Net Asset Value (NAV), is determined by adding up the worth of the securities the fund owns, plus any cash it holds, and dividing that by the number of shares outstanding.

Buy a fund at 2 p.m. and you'll pay a NAV that is determined two hours later. Buy a fund at 5 p.m. and you'll pay a price that won't be set until 4 p.m. the following day. According to Spitzer's complaint, Canary Capital Partners, a hedge fund, took advantage of the way fund prices are set to effectively pick the pockets of long-term shareholders.

What's a hedge fund?

A hedge fund is like a mutual fund in that it buys and sells securities, is run by a portfolio manager, and tries to make money for its investors. But hedge funds have a very different structure (they are actually set up as partnerships) and are almost entirely unregulated, mostly because they manage money for sophisticated high net-worth individuals or companies, and have different rules governing when and how investors can liquidate their positions.

Hedge-fund managers are compensated based on a percentage of profits (often 20%), so they have a major incentive to take risks, which they often do. Selling stocks short (a way to bet they will fall in price), piling on complex financial security derivatives, and using borrowed money to leverage returns are common strategies.

So exactly what did Canary Capital allegedly do?

According to Spitzer's complaint, Canary (which settled charges, paid $40 million in fines, but didn't admit or deny guilt), had two strategies (Spitzer called them "schemes") for making money trading in mutual funds. The easiest to understand, the most serious, and clearly illegal is "late trading." The other strategy, "market timing" is far more common and not illegal, although clearly unethical.

How does late trading work?

The rule of "forward pricing" prohibits orders placed after 4 p.m. from receiving that day's price. But Canary allegedly established relationships with a few financial firms, including Bank of America, so that orders placed after 4 p.m. would still get that day's price. In return for getting to trade late, Canary placed large investments in other Bank of America funds, effectively compensating the company for the privilege of trading late.

The late-trading ability would have allowed Canary to take advantage of events that occurred after the market closed -- events that would affect the prices of securities held in a fund's portfolio when the market opened the next day.

I could use an example.

Here's a hypothetical, simplified one: Let's say the Imaginary Stock mutual fund has 5% of its assets invested in the stock of XYZ Co. After the close, XYZ announces earnings that exceed analysts' expectations. XYZ closed at 4 p.m. at $40 a share but most likely, its price will soar the next day.

The late trader buys the Imaginary Stock mutual fund at 6 p.m. after the news is announced, paying an NAV of $15 (that was calculated using the $40 share price of XYZ). The next day, when XYZ closes at $50, it helps push the fund's NAV to $15.50. The late trader sells the shares and pockets the gain. Spitzer says late trading is like "betting today on yesterday's horse races." You already know the outcome before you place your winning bet.

How do they turn this into real money? It sounds like small potatoes.

If you did this dozens of times a year in hundreds of funds investing millions of dollars at a time, it would add up.

What about market-timing? How does that work?

This strategy takes advantage of prices that are already outdated, or "stale," when a fund's NAV is set. Most often the strategy is carried out using international funds, in which prices are stale because the securities closed earlier in a different time zone.

Could you give an example?

Well, let's take the Imaginary International Stock mutual fund. One day, U.S. markets get a huge boost thanks to positive economic news and the benchmark Standard & Poor's 500 rises 5%. The market-timer steps in and buys shares of the international fund at an NAV of $15 at 4 p.m., knowing that about 75% of the time, international markets will follow what happened in the U.S. the previous trading day. Predictably, most of the time, the international fund rises in price the next day and closes at an NAV of $15.05. The market-timer then sells the shares, pocketing the gain.

If market timing isn't illegal, why would Spitzer investigate the industry for it?

Market timing (and late trading, for that matter) add to a fund's costs, which are paid by shareholders. This kind of trading activity also either dilutes long-term profits or magnifies losses depending on whether the trader is betting the fund will go up or go down. (For a more detailed example of how market-timing works, see BW Online, 12/11/02, "How Arbs Can Burn Fund Investors").

Most funds have a stated policy in place (included in the prospectus) of prohibiting market-timing. They impose redemption fees on investors that hold a fund less than 180 days. And many prospectuses give fund companies the right to kick market-timers out of the fund.

Yet Spitzer alleges that fund companies such as Janus (JNS ) and Strong got to reap extra management fees by allowing Canary to do market-timing trades in return for Canary placing large deposits of "sticky" assets (funds that are going to stay in one place for a while) in other funds. That would put it in violation of its fiduciary duty to act in its shareholders' best interests and mean it has not conformed to policies laid out in its prospectus.

Spitzer offers this analogy: "Allowing timing is like a casino saying that it prohibits loaded dice, but then allowing favored gamblers to use loaded dice, in return for a piece of the action." Janus, Strong, and the other companies named in Spitzer's complaint have promised to cooperate with him and are conducting their own internal investigations of trading practices. Several firms have promised to make restitution to shareholders if they find such deals cost shareholders money.

But wouldn't this amount to tiny losses for the shareholders in the fund?

That depends on how many traders might have used these strategies. Spitzer believes these practices are widespread and his investigation is widening to include many more fund companies.

Eric Zitzewitz, an assistant professor of economics at Stanford, has found evidence of market timing and late trading across many fund families he studied. His research shows that an investor with $10,000 in an international fund would have lost an average of $110 to market timers in 2001 and $5 a year to after-market traders. Average losses in 2003 appear to be at roughly the same level, he says. That may not sound like much, but in a three-year bear market, when the average investor was losing hundreds if not thousands of dollars on investments, it's adding the insult of abused trust to the injury of heavy losses.

What's likely to happen next?

Spitzer and other securities regulators are likely to announce the alleged involvement of more fund companies. If individual investors believe fund companies abused their trust, they are likely to call for more regulation and stiff penalties. Potentially they could pull their money out of funds en masse, forcing portfolio managers to liquidate stocks to fund redemptions. That could be very disruptive to financial markets.

Another possibility is that the stock market continues to rise on the back of a stronger economy and a jump in corporate profits. Fund investors might be willing to ignore past losses due to illegal and unethical trading practices because they're pleased with the current gains their funds are providing. For now, that's clearly what the embattled mutual-fund industry hopes will happen.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Beth Belton

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