The probe of mutual fund trading practices unveiled last week by New York Atty. Gen. Eliot Spitzer has rocked the money management industry and left many on Wall Street wondering just what the scandal would mean for the stock market’s fledgling recovery.
Although sales could well suffer at the firms directly caught up in Spitzer’s inquiry, some analysts predict that most Americans will keep money in their mutual funds – at least for now.
Thanks to the rebound that has lifted the blue-chip Standard & Poor’s 500 index 16% this year, equity funds pulled in a net $57 billion in new cash from investors through July 31, reversing last year’s net redemptions. The market’s performance has held up even with the scandal.
“The good news is that this came out this year rather than in 2002, when everyone was looking for an excuse to sell,” said Don Cassidy, senior research analyst at Lipper Inc. in Denver.
If the scandal continues to widen, however, the damage could become a lot harder to repair.
“I hope that what’s happened is more of an incident than a catastrophe,” said Geoff Bobroff, a consultant to the fund industry in East Greenwich, R.I. “Otherwise, we run a risk of disrupting the confidence the industry has built up with investors over the last 20 years.”
The $6.9-trillion fund industry counts more than half of U.S. households as customers.
Until Spitzer’s bombshell last week, the industry enjoyed a reputation for probity. It was known for putting small investors on a level playing field with their bigger, more sophisticated counterparts.
Now, that is all in jeopardy. Some experts say the investigation could have as much effect as Spitzer’s Wall Street analyst probe, which led to a host of reforms as well as last spring’s $1.4-billion settlement with 10 major brokerage firms over conflicts of interest.
As one securities lawyer put it, “This is the tip of an enormous iceberg.”
The fund scandal erupted when Spitzer – who used New York’s far-reaching investor protection laws to force reforms on the brokerage industry – announced a $40-million settlement Wednesday with hedge fund group Canary Capital Partners involving “market timing” and “late trading” of mutual funds.
Hedge funds, which are loosely regulated and often secretive vehicles aimed at the wealthy, try to beat the market through various trading tactics. Late trading refers to unlawful, after-the-bell buying or selling of mutual fund shares at the old price – a tactic that allows people to take advantage of late-breaking, market-moving news. Spitzer likened late trading to “being permitted to bet on yesterday’s horse race.”
Market timing, although not illegal, is a quick-trading strategy that is strongly discouraged for individual investors. Spitzer said the trading drives up fund expenses and dilutes value from long-term shareholders, potentially costing them billions of dollars a year. By allowing it for some to the detriment of others, he said, funds are breaching their fiduciary duty.
Canary was allowed to profit from the trading schemes in exchange for parking long-term assets elsewhere at the fund firms, Spitzer said. Bank of America Corp.’s Nations Funds allowed late trading by Canary, while BofA and three other major firms – Bank One Corp.’s One Group, Janus Capital Group Inc. and Strong Capital Management Inc. – allowed Canary’s market timing, he said.
The Securities and Exchange Commission followed Spitzer on Thursday by launching a probe of its own into mutual fund trading practices.
No mutual fund companies have been formally charged with wrongdoing.
“It’s a disgrace: ‘Should we take this money and dilute our shareholders’ interest?’ ” said John C. Bogle Sr., founder and former chairman of Vanguard Group, the nation’s second-biggest fund firm. “Not much astonishes me anymore; this astonishes me.”
Even the sometimes combative Investment Company Institute, the fund industry’s main trade group, sounded betrayed last week.
“If the practices are as described, the rest of the fund industry is outraged,” said group Chairman Paul G. Haaga Jr.
Spitzer made clear that he expects to cast his net beyond the four fund providers he named last week. Indeed, Vanguard Group, Amvescap‘s Invesco Funds Group and the hedge fund Millennium Management have been subpoenaed by Spitzer for information.
One certainty that is shareholders will press more class- action suits, said Philip Aidikoff, a securities lawyer in Beverly Hills.
“The fact that some funds have had special relationships with some investors is a dirty little secret that a lot of people have known about,” Aidikoff said.
“We are scratching the surface of ways institutional investors are treated differently from regular investors.”
At least three lawsuits seeking class-action status have been filed, naming as defendants one or more of the four fund companies that have been singled out by Spitzer.
On the regulatory front, some industry analysts say the SEC faces pressure to clamp down on mutual funds.
The agency already had been considering a series of initiatives aimed at protecting mutual fund investors at the request of Rep. Richard H. Baker (R-La.), chairman of the House subcommittee on capital markets, and Rep. Michael G. Oxley (R-Ohio), chairman of the Financial Services Committee. The SEC is expected to respond by Oct. 1.
Among other steps, Baker and Oxley have called for better disclosure of fund fees and expenses and a greater number of independent directors. The Spitzer probe has pushed the SEC to expand its agenda on fund reform, and commission examiners began visiting fund companies Friday to inspect their trading operations.
In a statement late Friday, Janus announced several moves aimed at addressing the issues raised by Spitzer, including hiring an outside auditor to review the funds involved and promising restitution “to the extent that fund shareholders may have been adversely affected by the company’s discretionary market-timing arrangements.”
Amid the public relations nightmare, some say the industry may adopt a set of “best practices” standards covering areas such as market timing and upgrading computer systems to diminish the chance of late trading. Funds are valued once a day, at 4 p.m. Eastern time, and orders received after that are supposed to be processed at the next day’s closing price.
Market timing is harder to define than late trading and may not be easy to regulate, experts warn. For example, some say traders who hold a fund for only a week are as harmful as those who trade daily. Funds use redemption fees, “timing police,” trading limits and other measures to try to thwart timers.
“Timing is kind of in the eye of the beholder,” Haaga said. At Los Angeles-based Capital Research & Management Co., where he works as an executive vice president, the firm let go one market timer from its American Funds “and then he tried to come back saying he was a ‘tactical asset allocator.’ “