Mutual Mess
The fund scandal grows and grows
It appears that the corruption that has befouled Wall Street has finally oozed its way onto Main Street. During congressional hearings last week, federal and state regulators said they had uncovered widespread skimming of mutual funds, long billed as the safest and smartest investments for middle-class Americans. The industry "is a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation's household, college, and retirement savings," says Illinois Sen. Peter Fitzgerald, who chaired one of the hearings.
It wasn't newly revealed rip-offs that drew gasps so much as evidence of how deep the culture of greed is in the industry. Last week, two new names were added to the list of suspect funds that already includes giants like Janus, Strong Mutual Funds, Bank of America, and Putnam Investments. Alliance Capital Management acknowledged that it was the target of an investigation by the Securities and Exchange Commission over "market timing," the flitting in and out of funds to capitalize on temporary share-price discrepancies. And Massachusetts charged five former Prudential Securities employees with conducting a sophisticated scheme involving market timing and "late trading." Late trading is the buying of fund shares at the closing price after the deadline to take advantage of after-market events.
But government watchdogs say the bigger outrage is that these trading abuses were just part of a pattern of practices that have cheated and overcharged investors for years. "This is no longer a case of one or two bad apples," says New York Attorney General Eliot Spitzer. "It is beginning to appear as though the entire crate is rotten."
Defense. Mutual fund industry officials professed shock and dismay at the latest accusations but insisted they were isolated incidents. "Not every failure is a failure of all systems," says Paul Haaga, chairman of the Investment Company Institute, the trade association that represents mutual fund firms. And some of the practices under attack, such as fund fees (critics say they are too high) and management structures (critics say they are too cozy) are above board and good for investors, says ICI.
Maybe. But late trading, at least, is not only illegal but also costly to long-term investors. Stephen Cutler, the SEC's director of enforcement, said the agency now suspects as many as 10 percent of all mutual fund firms have permitted at least one favored investor to routinely place late orders.
Market timing, on the other hand, is more controversial. It's perfectly legal and, indeed, smart, to time the market by buying low and selling high. But rapid trading is an expensive prospect for a mutual fund firm and reduces returns for long-term investors. That's why most firms have strict rules against churning--and it's illegal to violate them. Two former Putnam managers now face market-timing charges. Strong Financial founder Richard Strong is under investigation for timing his own funds.
There are likely to be many more such allegations. An SEC survey of 88 of the largest mutual fund firms released last week found that almost half had allowed certain investors to churn. A common ploy: buying shares of international funds that failed to quickly update prices to account for overseas events, then selling after the fund updated the price in a day or two. Eric Zitzewitz, an assistant professor at Stanford University's Graduate School of Business who studies the industry, estimates that late traders cost market timers $5 billion; long-term investors, an additional $400 million a year.
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