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Many Mutual Funds Are Caught Ignoring Ethical
Standards
Some of the best-known names in the mutual fund
industry have come under attack by the New York
attorney general’s office and the SEC. Over 300
lawsuits against 18 different firms were filed and
consolidated in federal court in Baltimore. The
mutual funds are eager to settle the suits and to get
the bad publicity behind them. Nine firms agreed to
pay $1.6 billion in restitution to investors and an
additional $855 million in fee reductions. Among
the larger settlements were the following:
•
The Alliance Capital Management Corp. was
charged with allowing traders to engage in mar-
ket timing. The firm will cut fees by $350 million
and pay $250 million in fines and restitution to
shareholders.
•
Bank of America, which was implicated along with
Canary Capital Partners in late trading and market
timing, agreed to fee reductions of $160 million
and fines and restitution of $375 million.
•
Janus Capital Management LLC will reduce fees
by $125 million and pay fines and restitution of
$100 million.
•
Putnam Investments, the fifth-largest family of
funds, agreed to pay $10 million in fee reduc-
tions and $100 million in fines and restitution.
In addition to the fines, restitution, and fee reductions,
some individual investment managers were charged
with criminal activity. The vice-chairperson of Fred Alger
& Company, James Connelly Jr., was sentenced to one
to three years in jail for his involvement in preferential
treatment and self-dealing in the mutual fund.
Source: Wall Street Journal, July 14, 2004, p. C1.
Shareholders depend on directors to monitor investment advisors. Unfortunately,
recent evidence demonstrates that directors’ efforts have not been sufficient to pre-
vent abuses. The incentive structure for compensating investment advisers does
not assure that they will be motivated to maximize shareholder wealth. In the absence
of monitoring, investment advisers will attempt to increase their own fees and income,
even at the expense of shareholders. For example, suppose an institutional investor
offers to make a large deposit into the fund in exchange for special trading privi-
leges not afforded other investors. Since investment advisors are compensated as a
percentage of the funds under management, they may choose to provide the spe-
cial treatment because it increases their income. The recent negative publicity about
mutual funds is due to this type of misaligned interest. The Conflicts of Interest box
discusses some of the better-known mutual fund scandals.
Mutual Fund Abuses
Until 2001, the mutual fund industry could brag that it had been “untainted by major
scandal for more than 60 years.”
3
This changed when the New York attorney general
began investigating tips that mutual funds were engaging in various activities that
undermined their fiduciary duty to shareholders, violated their own policies, and
in some cases broke SEC laws. Most of the abuses centered around two activities:
late trading and market timing, both of which take advantage of the structure of
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Part 6 The Financial Institutions Industry
open-end mutual funds that provide daily liquidity to shareholders by marking all
trades to the NAV as of the close of business at 4:00
PM
.
1. Late trading.
Late trading refers to the practice of allowing trades that are
received after 4:00
PM
to trade at the 4:00 price when they should trade at
the next day’s price. Suppose that on Wednesday at 4:00
PM
the NAV for a tech-
nology fund is $20. Now suppose that news is received by traders at 6:00
PM
that HP, Intel, and Microsoft have reported their income surged 50% over the
last quarter. Traders, knowing the industry impact this will have, may want
to enter buy orders for the fund at the $20 price. They are sure the NAV on
Thursday will be substantially higher and they can earn a quick profit. A late
trader can trade at the stale 4:00
PM
price and buy or sell the funds the next
day at a profit.
The attorney general reported in hearings before Congress that “late trad-
ing is like betting on a horse race after the horses have crossed the finish
line.” It is illegal under SEC regulations. The reason it went undetected for
many years is that certain late trades were regularly accepted and were legal.
If a broker received a buy order from a client at 2:00, the order might not
get consolidated with other orders and transmitted to the fund by 4:00. Since
the investor placed the order before the market closed, the investor could
not benefit from the late trade. Late trades were simply an opportunity to
catch up with order processing. It was when large investors took advantage
of their special arrangements at the expense of other shareholders that the
legal line was crossed.
2. Market timing.
Market timing, though technically legal, is considered
unethical and is expressly forbidden by virtually all mutual funds’ policy stan-
dards. Market timing involves taking advantage of time zone differences
that allow arbitrage opportunities, especially in foreign stocks. Mutual funds
will set their 4:00 closing NAV using the most recent available foreign prices.
However, these prices may be very stale. Japan, for example, closes nine
hours earlier. If news is released in Japan that is not reflected in their clos-
ing prices, arbitrage opportunities exist by buying at the stale prices embed-
ded in the NAV.
Most mutual funds have fees that are supposed to discourage these kinds of rapid
in-and-out trades. However, if an investor such as Bank of America places large
deposits in the fund, these fees can be waived. This is exactly what Edward J. Stern
and his hedge fund Canary Capital Partners LLC did. In September 2003, Stern set-
tled with the attorney general for $40 million in fines for allowing both late trading
and market timing by Bank of America.
To better understand how shareholders in mutual funds are hurt by market tim-
ing and late trading, suppose a technology fund holds stock in various firms with
a total current market value of $350. Further suppose you own one of 10 shares
outstanding in the fund. The NAV of the fund will be $35 per share ($350/10).
Now suppose that after the market closes the tech industry announces better-than-
expected earnings that everyone agrees will drive the value of shares held by the
fund to $400 when the market opens the next morning. The NAV of your share
would be $40 ($400/10). However, if another investor with special privileges is
allowed to buy a share in the fund for $35 after hours, your NAV will be diluted. The
$35 received by the fund from the privileged investor will have to be held as cash
Chapter 20 The Mutual Fund Industry
509
4
See Eric Zitzewitz, Journal of Law, Economics & Organization 19, no. 2 (2003): 245–280; Jason
Greene and Charles Hodges, Journal of Financial Economics 65 (2002): 131–158; and Goetzmann,
Ivkovic, and Rouwenhorst, Journal of Financial and Quantitative Analysis 36, no. 3 (September
2001): 287–309.
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