How the Mutual Fund Scandals Affect You?

mutual fund scandal

The growing scandals in the mutual fund industry have implications for all of us, not just the few big shots who are resigning from their ivory tower positions.

In case you don”t know about this story, let’s take it from the top!

The mutual fund industry is currently involved in three scandals:

A. The first involves market timing, which is legal but improper.

B. The second involves the financial industry failing to give discounts on mutual fund commissions, a practice which is probably illegal and definitely improper.

C. The third involves late trading, which is both illegal and improper!

In the market timing scandal, investors are trying to take advantage of disparities between the price of a fund”s shares and the values of its underlying securities in a portfolio.

The participants dart in and out of funds. This practice isn’t necessarily illegal, but most mutual-fund companies have policies to discourage or bar market timing because it harms long-term investors, primarily by reducing their potential profits.

Oftentimes, fund insiders do the trading. Putnam mutual funds, the fifth-largest mutual fund firm in the country, said that six of its employees netted $700,000 in timing trades.

The chief executive of Putnam, Lawrence J. Lasser, will get the axe. But don”t feel sorry for him: he’s due to receive about $89 million upon his departure.

The founder of the Strong Funds, Richard Strong, has stepped down because of the flap. Spitzer says Strong and others close to him netted $600,000 over five years by market-timing practices, to the detriment of long-term investors like you!

Massachusetts regulators are expected to charge that Prudential Securities, Inc. received more than 25,000 warning letters in the past year from mutual-fund firms that its brokers were engaged in improper market-timing of mutual funds, but did nothing to curtail the practice.

Last week, a dozen stockbrokers and managers at Prudential Securities resigned under internal pressure. Let’s see what external pressure will do.

In the second scandal, the National Association of Securities Dealers (NASD), the brokerage industry watchdog, in conjunction with the Securities Exchange Commission (SEC), the federal securities watchdog, disclosed that mutual-fund investors failed to receive an estimated $86 million of discounts on fund commissions during 2001 and 2002.

Consequently, securities regulators are planning to bring enforcement actions against about two dozen brokerage firms for overcharging customers who bought large amounts of mutual-fund shares.

This scandal has to do with something called “breakpoints.” If you buy a mutual fund through a broker, that broker has to get paid somehow. Oftentimes you pay the broker by commission.

If you invest $10,000 in a mutual fund and the fund has a 4% commission, the commission will be $400. The mutual fund keeps some of the commission and sends the rest to the broker’s firm in what’s called a “reallowance.”

The broker and his firm share the reallowance. But the commission rate goes down for those who invest larger sums of money. For example, if you invest $100,000 in the same fund, your commission may be only 3.5%.

If you invest $500,000, your commission may only be 2.5%. Those different levels are called breakpoints and, the more you invest, the less you pay percentage-wise.

The regulators charge that all those brokers failed to honor the breakpoints, meaning that the investors paid higher commissions than were told to them by the brokers or stated in the prospectuses.

Where did all the extra dough go? Naturally, into the pockets of the brokers and mutual fund companies!

Now comes the third, and biggest scandal!

Unlike stocks, which trade continuously from 9:30 to 4:00 eastern time on business days, mutual fund prices are set only once a day and are determined by measuring the value of all the assets in the mutual funds. The fund values are established within a few hours after the markets” 4:00 close. (That’s a simplistic explanation, but one that’s good enough.)

If you buy a mutual fund before the 4:00 close, you will be given that day’s closing price. If you switch from one mutual fund to another before 4:00, you will sell the old mutual fund as of that day’s closing price and buy the new fund at its closing price.

If you call your mutual fund company after the 4:00 close, you will place your trade at the next day’s closing price.

At least that’s how the system is supposed to work. The reality of the situation is somewhat different. Some favored traders were allowed to make mutual fund transactions after 4:00 and still receive that same day’s closing mutual fund price.

In fact, some mutual funds didn’t even do such basic tasks as date/time stamping orders as they came in, thereby confusing the matter even further.

All of this hurts you, the long-term investor who is playing by the rules. In conducting recent checks, the SEC said it found that 25% of brokerage firms allowed clients to place potentially illegal “late” orders for mutual-fund shares and that three fund companies appeared to have arrangements that allowed such late trading.

Additionally, the SEC said that about 30% of the brokerage firms may have actively assisted some investors in conducting improper trading. The SEC says it has sent “detailed information requests” to 80 of the nation’s largest mutual-fund complexes, to prime brokerage firms, transfer agents, and large broker-dealers. So possibly more funds will face charges of “late trading” and “market timing.”

This story gathered steam when Spitzer announced September 3 a $40 million settlement agreement with Canary Capital Partners – a multimillion-dollar hedge fund, two Canary-related entities, and Edward Stern, the managing principal of these entities.

Canary Capital, which admitted no wrongdoing, was charged with obtaining special trading opportunities with leading mutual fund companies, including Bank of America’s Nations Funds, Banc One, Janus, and Strong.

You may be asking why this is such a big deal. To answer that question, picture this:

Suppose the stock market closed today without much direction. Then, after the close, some giant company like Microsoft or IBM reports really bad news, or that some catastrophic event takes place in the world. Everyone knows that the market will sink tomorrow.

If you had the chance to sell your positions at today’s closing prices, even though the market has already closed, would you do it? Think about that for a second!

The event need not be a bad one, either. A big company may report good news, or we might find out that the U.S. has captured or killed a prominent foreign terrorist. There’s a big likelihood that the market will skyrocket tomorrow. Would you buy if you could?

In many cases, the answer was “yes,” and such late trading done under the acquiescing eye of the mutual fund companies involved.

This type of trading is illegal, because a lucky investor gets the same day’s price on order placed after 4:00, enabling him to place trades in accordance with news that happens after hours. It’s like getting a 24-hour head start on other mutual fund investors and being able to use tomorrow’s information today!

Spitzer has accused the SEC of sleeping at the switch. His accusation is true: Spitzer was the one who brought the big corporate scandals to light. Now he is the first to reveal these mutual fund scandals. Spitzer wants the publicity.

That’s fine – let him have it. Investors will be thankful.

How does this affect you?

If you invested a large amount of money into a mutual fund, make sure you didn’t pay too much in the way of commissions. Most likely, it affects you in the return you receive on your fund.

If your fund doesn’t match the performance of the overall market, that’s normal: most mutual funds don’t measure up to the overall market indices.

As Gordon Gekko said in the movie “Wall Street,” “[Fund managers] are sheep, and sheep get slaughtered.”

Is your fund company involved in one of these three scandals? You had better call their toll-free number to find out, or do some independent research on the Web.

If nothing else, this scandal should make you think about whether you can do a better job investing than the manager you hired!

By The Money Management Firm, Inc.