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Neville Bennett: Fraud in Mutual Funds

Fraud in Mutual Funds

Dr. Neville Bennett
November 12, 2003

The greatest scandal in the history of the mutual fund industry has sent the American saving market reeling. A quarter of the nation’s broker-dealers engaged in illegal late trading. Half of the biggest mutual funds let certain shareholders engage in "market timing" deals that are banned in their prospectuses. 30% of fund manger admitted they gave sensitive portfolio information to privileged individuals.

This provides new evidence that the culture in the industry needs fundamental remedial behaviour modification. Managers ignore clear rules when profitable opportunities arise.

The core of the latest scandal broke some weeks ago (NBR September12) when Canary Capital Partners, a hedge fund, was permitted by Janus Funds to trade its shares after the closing bell, and when it knew by international activity, that the fund was a "buy" or "sell" ("late trading’).

Another practice is called "market timing" or "international fund arbitrage". Here is how it works. A fund announces its price at 4 o’clock in New York. Before the next morning, there are trades in international markets, and "timers’ are permitted to buy into the fund the next morning at the previous day’s price. It is money for jam. Managers do not always mind it because they get activity fees and greater turnover. While some funds have "police’ who watch for big, give-away trades, Spitzer says ‘dozens" of funds condone timing even though their prospectuses say timing is not permitted.

Another allegation is that funds provided an up-to-the-minute record of their portfolio to hedge funds. Investors get told very infrequently what they have shares in. Hedge funds know immediately and this improves their trading opportunities.

This malfeasance is being investigated simultaneously by a lot of heavy hitters. As 95 million Americans hold mutual funds, the issue is paramount in politics. Both the Senate and House are holding inquiries. So are the Securities and Exchange Commission, and the State of Massachusetts. Earl Spitzer seems to be testifying at all the hearings.

Spitzer seems to be raising the heat by going beyond management to the board level. He believes boards condoned conflicts of interest in order to increase fee income. "The governing structure has failed’, he pronounces, and demands that chairmen have no contact with management or advisory boards.

Meanwhile the scandal has claimed some big names. Richard Strong has resigned as chair of Strong Mutual Funds. Strong has US$47 billion under management, and said that it would not engage in market timing. Its Chair and CEO did. Strong says he did it for his family and a few friends. One trusts that these favoured individuals will visit Mr. Strong in the penitentiary, should that be his place of destiny. Spitzer will file criminal charges this week.

Spitzer has a good track record. Last year he spearheaded a ground-breaking investigation into Wall Street securities firms which resulted in a US$1.4 billion settlement aimed at cleaning up research. Spitzer found that some Wall Street firms were recommending firms because of broker’s vested interests. Citigroup for example was obliged to separate its research and brokerage houses.

The biggest casualty is Putnam’s. Putnam’s was the fifth biggest mutual fund with US$272 billion under management. It is alleged that some managers allowed late and market timing. The market has savaged it. State pension funds of Massachusetts, Rhode Island, Iowa and many teachers’ pension funds have been withdrawn. The CEO has stepped down, but many observers feel that Putnam cannot recover. So far, it is the only firm facing criminal and civil law charges.


- Dr. Neville Bennett
Christchurch, New Zealand

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