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How mutual funds stole your money
While your shares were handcuffed by 4 p.m. closing prices, others could wait for hours -- sometimes until the next day -- before swooping in on good or bad news to make a killing.
By Jon D. Markman
As new allegations of Wall Street wrongdoing surface virtually every day, it's hard to escape the conclusion that three years of manic-depressive stock prices, major corporate bankruptcies, and the prosecution of analysts, insider-trading and IPO frauds did nothing to inhibit a pervasive culture of corruption in much of the mutual fund industry.
It's unclear whether this came about because of pressure to produce results at any cost, a blurred line between aggressive and illegal behavior or an expectation of light punishment for out-of-bounds acts. Whatever the reason, an alarming number of fund managers and their salespeople at brokerages appear to have slipped into a habit of unlawful acts that breached their fiduciary responsibility to retail customers and cost investors billions of dollars.
At first, it seemed that just a handful of fund firms were involved. But new evidence suggests that large swaths of the fund industry have systematically leveraged legal loopholes and lax enforcement by federal regulators to become the white-collar equivalent of organized crime, shaking down a quarter here and a dollar there from a public that had become its patsies.
Half the industry is probably implicated in one way or another, says Mercer Bullard, a former Securities and Exchange Commission counsel who now teaches law at the University of Mississippi.
The cost to mutual fund consumers could be staggering. According to estimates, the hidden price of managers venality may have been enough to double the reported expenses of some funds at companies that engaged in unsavory practices. So if you believe youre paying 1.5% in fund expenses, or $1,500 per year for a $100,000 investment, the hidden costs may have been more like $3,000. So you would need to make at least 3% a year just to get out of the hole in a typical no-load fund. In a fund with a 5% load, youd need to make as much as 8% a year just to start making money.
Lots of dough
Thats not small change in a $7 trillion industry. Lawrence Lasser, disgraced former head of mutual-fund powerhouse Putnam Investments, took home $30 million annually over the past six years until he was ousted over improper trade allegations at his Boston firm. He certainly didnt make that by enriching his retail customers. In the past five years, the median annualized return of all Putnam stock funds in the MSN Money database is 0.6%.
If your fund hasnt surfaced in the scandal yet, dont be too smug. The SEC last week said it believes that as many as half of all mutual funds allowed preferred customers to engage in a borderline-illegal practice known by the misnomer market timing. Meantime, as many as 25% gave those elite customers the ability to employ an outright fraudulent practice known as "late trading.
- Market timing: Large customers were allowed to profit either from quick trades on stale prices in illiquid bond funds or from time-zone differences in the prices of international stock funds. Because most funds restrict investors to a maximum of four to six trades per year, these customers in some cases were permitted to create smurf" accounts to hide their actions -- a technique long used by money-launderers. Just as cartoon Smurfs all have the same blue bodies but different names, smurf accounts have different names on their titles but actually belong to a single person or corporate entity.
- Late trading: Large customers were allowed to buy mutual funds at closing prices after 4 p.m., permitting them to benefit from price-moving news after hours.
Private attorneys who've filed lawsuits against funds now say that these publicized practices are just the tip of the iceberg. One attorney told me that insiders have come forward to allege that late trading in some cases occurred as late as an hour into the next days trading.
Weve been approached by whistle-blowers at various major funds and have gotten the sense that the practice was endemic, said Robert Nelson, an attorney at Lieff Cabraser Heimann & Bernstein. At some places, with management approval, you could get a Tuesday fund price an hour into trading on a Wednesday. Because of the way shares were cleared, the potential for abuse was enormous.
The critical piece
Indeed, the way fund purchases are cleared, or recorded, is critical. While stocks are bought and sold all day long, funds are priced just once a day. When an investor buys $10,000 of a mutual fund, the price is supposed to be the funds 4 p.m. net asset value. The number is derived by first dividing the price of all its stocks by the number of shares to arrive at a total asset value. Then accrued expenses, such as accounting, are subtracted to arrive at the net asset value. The investor is issued new shares at that dollar amount.
Each evening, a torrent of orders from individuals and the nations thousands of retirement plan administrators piles up at fund-clearing firms. The process is automated, of course, but its also a madhouse. Some funds do the job themselves, but many in recent years have outsourced the work to third parties, which in some cases have outsourced it to fourth parties.
The late traders exploited the chaotic weakness of this system. In some cases, they appear to have found ways to persuade clearinghouse workers to put a 4 p.m. time stamp on orders submitted later. In other cases, the late-traders submitted two orders for a single fund before the closing bell -- one to buy and one to sell -- and then when news broke after hours were permitted to cancel one. If you can get someone to agree to accept the order, it doesnt matter when the cutoff is, said Bullard, the former SEC lawyer.
Why would fund companies allow this? Nelson points to a culture focused on bringing in as much money as possible, a culture where growth trumped integrity. The pressure to succeed intensified during the bear-market of 2000 to 2002 when it was as hard to make money on stocks as it was to entice new investors to buy them. Aggressive brokers courted hedge funds that would park millions of dollars at a fund firm in exchange for special privileges that allowed them, essentially, to manufacture money out of thin air. It was a way to make their funds more attractive to an elite class of short-term traders at the expense of long-term investors, said Nelson.
Late-trading allowed firms to boost their assets under management and generate income by renting out the hedge funds cash balances to other investors under margin agreements. Market timing -- which required a lot of trading -- showered brokers with commissions. The harm to consumers came in many forms:
- Late trades were clearly a criminal fraud that cheated law-abiding investors who innocently took the other side of a loaded transaction.
- Market-timing threw off a lot more capital gains than the fund otherwise would have incurred, a cost borne equally by all fund holders. In addition, fund managers were required to hold a lot more cash than they otherwise might have wished in order to meet redemptions. Holding cash can create a drag on performance.
No surprise
Bedda Emous, a fee-only financial planner in Massachusetts who worked for many years at large trust companies, hasn't been shocked by these revelations. She's seen time and again that fund management firms like Putnam had little concern for the little guy. Its all about how to build the distribution network by pleasing the broker, she said. They didnt see the end user as a human being. The only thing that mattered was meeting sales goals, just like a car dealer.
The winner in all this may end up being independent money managers who buy individual stocks in separate accounts. Ken Winans, president of Winans International in the San Francisco Bay Area, said his business is up about 10% in recent weeks as clients have given him a portion of their money they held elsewhere in funds. Funds have been given a lot of latitude and trust, and they have betrayed that trust, Winans said. His sales pitch: A typical mid-cap mutual fund charges 1.5% in fees, and you dont know exactly what you own, and you cant control the tax consequences of sales. In contrast, he charges 1% (plus about another 0.3% for commissions), and a client has total transparency into every transaction, as well as control over taxable events.
If you prefer to stick to funds, ask hard questions and dont deal with any implicated in the scandal -- no matter how much they protest theyll never do it again. It might be wise to focus on smaller outfits that are employee-owned and/or require their managers to invest in their own funds. A few with good records, no sales loads and low expenses are Hussman Funds, Ariel, Muhlenkamp, Wasatch Advisors, Mairs & Power, Dodge & Cox, Clipper and Longleaf.
| Funds without complexes | | Fund Name | YTD % return | 3-yr % return * | Sharpe ratio | 11/7/03 NAV | | Hussman Strategic Growth (HSGFX) | 16.66 | 20.89 | 1.64 | $14.76 | | Ariel (ARGFX) | 22.81 | 13.56 | 0.67 | $43.28 | | Longleaf Partners (LLPFX) | 29.95 | 12.63 | 0.55 | $28.90 | | Dodge & Cox Stock (DODGX) | 23.35 | 9.14 | 0.39 | $107.19 | | Clipper (CFIMX) | 12.06 | 9.15 | 0.38 | $84.86 | | Muhlenkamp (MUHLX) | 41.11 | 8.59 | 0.22 | $60.52 |
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*Annualized
Fine Print
John Hussman, the former finance professor who runs Hussman Strategic Growth (HSGFX) in Maryland, writes an excellent weekly column about investing and economics at his site. In the last installment, he listed every trade he had made in his fund since inception. His fund did exceptionally well during the bear market due to his timing the market (different from timing mutual funds) and hedging techniques, which is why he legitimately can recommend that investors put money in regularly without regard to their own timing beliefs. He adds: Save first, not last. Read it here. . . . Most of the longtime great Wasatch funds are closed to new investors, but you can still purchase Wasatch Global Science and Technology (WAGTX) and Wasatch International Growth (WAIGX). . . . Longleaf Partners (LLPFX), Mairs & Power Growth (MPGFX) and Dodge & Cox (DODGX) have shown again why they deserve investors trust, posting better than 22% returns this year, as well as better than 10% returns annualized in the past five years. . . . Readers continue to send smart, ferocious, heartfelt responses to my columns on China trade. Read them at my personal Web site.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdm@oddpost.com. At the time of publication, Markman was long the following securities mentioned in this column: Hussman Strategic Growth (HSGFX), Dodge & Cox (DODGX), Clipper (CFIMX) and Ariel (ARGFX).
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