Financial Markets and Institutions (2-downloads)

SEC Survey Reports Mutual Fund Abuses

Widespread

When the New York attorney general announced

that his office was going to indict a number of

mutual fund managers in September 2003, he

caught many regulators off guard. Their focus had

been on security abuses by corporations. The revela-

tion that the mutual fund industry might also be dirty

resulted in rapidly called hearings before Congress.

At these hearings Stephen Cutler, the chief of

enforcement for the SEC, presented results that

showed that illegal trading in mutual funds was more

widespread than anyone had imagined. In a sample

of the largest 88 mutual fund companies, which rep-

resented 90% of the industry’s assets, the SEC said

that about 25% of the broker-dealers were allowed

to make illegal late trades. Additionally, half the

funds let some privileged shareholders engage in

market timing trades. Finally, the research showed

that more than 30% of the funds admitted that their

managers had shared sensitive portfolio information

with favored shareholders.

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Part 6 The Financial Institutions Industry

• Hardening of the 4:00 

PM

valuation rule.

By more strictly enforcing the

rule that trades received after 4:00 be traded at the next day’s NAV rather

than at the stale NAV, late trading activities should be prevented. These pro-

posals, however, are controversial because they penalize investors whose

trades do not get completed due to trading backlogs. They also fail to pre-

vent market timing arbitrage across time zones.

• Increased and enforced redemption fees.

Most funds already have a policy

against market timing and have a redemption fee that is imposed for shares

that are sold within 60 or 90 days of purchase. These fees are usually discre-

tionary and were waived in the cases where abuses occurred. The problem

with mandatory fees is that they may penalize the investor who needs to

make an unexpected withdrawal due to an emergency. This penalty makes

mutual funds less attractive and, critics contend, would reduce their popular-

ity. As a result of this argument, in March 2005, a voluntary redemption fee

rule was adopted. The rule requires that the board consider whether they

should impose the fee to protect shareholders from market timing abuses.

• Increased transparency.

Other regulations follow the most common

approach taken by the SEC—increased disclosure of operating practices to

the public. Directors are required to more clearly and openly reveal any

relationships that exist between fund owners or investment managers.

Investment managers are required to more clearly disclose compensation

arrangements and how fees are charged. Additionally, more information is

required about compensation arrangements between the mutual fund and

sales brokers. This strategy leaves it to the market to discipline firms that

seek to exploit any conflicts of interest.

S U M M A R Y

1. Mutual funds have grown rapidly over the last two

decades. The growth has been partly fueled by the

increase in the number of investors who are respon-

sible for managing their own retirement. Increased

liquidity and diversification, among other factors,

have also been important. There are currently over

8,700 separate mutual funds with over $10 trillion in

net assets.

2. Mutual funds can be organized as either open- or

closed-end funds. Closed-end funds issue stock in

the fund at an initial offering and do not accept addi-

tional funds. Most new funds are organized as open-

end funds and issue additional shares when new

money is received. The net asset value (NAV) of the

shares is computed each day. All trades conducted

that day are at the NAV.

3. The primary classes of mutual funds are stock funds,

bond funds, hybrid funds, and money market funds.

Stock and bond funds can be either actively managed

by investment managers or can be structured as index

funds that contain the securities in some index, such

as the S&P 500.