Illicit trades in mutual fund scandal steal a little from many

Fraud costs small investors $400 million a year, by Spitzer’s reckoning

By HANK EZELL Cox News Service

Sunday, October 12, 2003

Atlanta — People used to tell the story about the payroll supervisor who got rich because he managed the big company’s first computer.

The tale was that he jiggered the programming so he got a dime out each paycheck the computer printed out. Nobody ever figured it out, or if they did, they decided it wasn’t worth fighting over a dime.

From the viewpoint of an everyday investor, the 5-week-old mutual fund scandal seems to have gotten to just about the same place.

Some people have gotten rich. They did it, experts say, with illicit trades that shaved a little slice off the profits of hundreds of thousands of ordinary investors. And most of those ordinary investors have no idea whether their own accounts were trimmed, or by how much.

The scandal erupted Sept. 3, when New York Attorney General Eliot Spitzer announced that a hedge fund, Canary Capital Partners, had paid $40 million to settle a complaint that it traded illegally in mutual fund shares. Spitzer said the machinations cost small investors an estimated $400 million a year.

Spitzer said that Bank of America facilitated the illegal trades in its Nations Funds, and that other mutual fund families participated in trading that was legal but unfairly hurt investors.

It could turn out that most individual investors lost small amounts.

“This is stealing a little bit from a whole heck of a lot of people,” said Don Phillips, managing director of the fund tracking company Morningstar. “The numbers become huge only when you think of the huge number of victims involved.”

His best guess: A $50,000 retirement account has lost “tens of dollars, not hundreds of dollars.”

But total losses have been enormous. Late trading cost investors an estimated $400 million a year, according to a study from Eric Zitzewitz, an economics professor at Stanford University. His study covers trading from 1998 through 2001, and in 2003.

There certainly are plenty of losers among 95 million Americans who have mutual fund accounts. That total includes millions of 401(k)s and other retirement plans.

And the list of malefactors is just beginning to shape up. So far one company has made a cash settlement without admitting wrongdoing, one man is awaiting trial and another man has pleaded guilty.

Spitzer has said the illicit trading is widespread and accelerating, and that he is pursuing an aggressive investigation.

The federal Securities and Exchange Commission joined the chase after Spitzer’s first complaint. In a surprise announcement last week, SEC Chairman William Donaldson said the agency will consider new curbs on mutual fund trading.

The details are complex and seemingly infinite, but the core complaint is that traders with money and connections rigged the game. There were two methods, late trading and market timing.

Late trading is illegal. The price of mutual fund shares is established each day at 4 p.m. If you buy or sell before the deadline, you get the 4 p.m. price. If you trade later, the law says you have to wait until 4 p.m. EST on the next trading day to find out what the shares are worth.

Late trading occurs when an investor places his order after 4 p.m. — presumably with knowledge of late-breaking events — but still gets the 4 p.m. price.

Market timing is not illegal, but most mutual fund managers assure their investors that they try hard to keep it from happening.

Spitzer said Canary had market timing agreements with dozens of mutual fund families. He identified three funds he said allowed market timing by Canary: Janus Capital Corp., Menomonee Falls-based Strong Financial Corp. and the One Group funds operated by a Bank One subsidiary. All three have promised restitution.

A timer dodges in and out of a given mutual fund, buying and selling frequently, sometimes daily.

In each practice, the trader is trying to take advantage of prices that have not been adequately updated. International funds are vulnerable when the 4 p.m. prices don’t reflect price changes in overseas stock markets. Thinly traded equities, such as small-cap stocks and high-yield and municipal bonds, are also vulnerable.