“The world’s largest skimming operation… A 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.” This is how Republican senator Peter Fitzgerald describes America’s $7 trillion mutual fund industry.
The market timing and late trading scandal that is swirling around the US markets — and has already led to the closure of one American bank and a haemorrhaging of funds from Boston-based Putnam Investments — was last week revealed to have reached Edinburgh.
Standard Life Investments, based in the capital’s George Street, let it be known at an industry seminar that its Far Eastern funds have been targeted by “market timers” at least twice.
Sandy Crombie, chief executive of SLI, told the Sunday Herald: “It is not difficult to spot [market timers] when they try to come into one of your funds. They are like an elephant in the refrigerator. We reported both instances to the Financial Services Authority with a full description.
“In both instances they were trying to exploit the difference between the so-called ‘stale’ prices in our funds and subsequent market movements probably in Far Eastern markets. It was spotted by our risk managers. This happened a couple of years ago.”
The market timing scandal commenced in the US, where the $7 trillion mutual fund industry is this weekend pondering its future as New York state attorney-general Eliot Spitzer steps up his investigation into a range of misdemeanours that have enriched favoured investors — such as hedge funds and arbitrageurs — at the expense of around 95 million ordinary retail investors.
The practices, which include market timing and late trading, have increasingly come to light since the energetic government prosecutor commenced his latest inquiry over the summer. They have since been shown to be fairly prevalent in the US savings market.
In the US, the Securities and Exchange Commission (SEC) has said that one quarter of mutual fund firms have indulged, while Eric Zitzewitz, an assistant professor at Stanford University who has studied mutual funds, said 90% of mutual funds in his sample engaged in market timing.
In both market timing (which is not illegal but considered unethical) and late trading (which is both), a fund management firm grants special privileges to their own insiders, or to specialist investors such as hedge funds and arbitrageurs at the expense of ordinary retail customers and holders of 401(k) retirement plans.
The mutual funds do this by, among other things, allowing the professional investors to exploit time differences across world markets by trading on the basis of new information — such as market movements in Europe and Asia — but to buy or sell at unit prices that were fixed at 4pm the previous day.
They then sell or buy once the fund is repriced, making themselves a small margin, often on a big slug of shares in the mutual fund, which has the effect of diluting value for the mass of “buy and hold” investors.
On one occasion, a market timer offered SLI higher fees in exchange for turning a blind eye to the transaction, but the investment management firm politely declined the request and instead reported the incident to the FSA.
The FSA went on to launch its own inquiry into market timing and late trading in the UK in October, sending out questionnaires to fund management firms. Ten days ago Callum McCarthy, chairman of the FSA, declared that it is unlikely that the UK’s £220bn unit trust industry has been immune. He says: “We’re investigating to see whether there have been problems of [market] timing.
“We have done a first cut, and that first cut has emphatically not given us the answer ‘No, there is no prospect of this happening in the London markets.’ We’re therefore doing a second cut to try and establish the position more clearly.”
Richard Burns, senior partner at Edinburgh-based investment partnership Baillie Gifford & Co, believes the market timing scandal in the US is “absolutely shocking”.
He says: “Allowing market timers and late traders into your funds clearly increases the overall assets, which can be good news for the sales people who are often incentivised according to gross sales. It makes the funds bigger than they would otherwise be.”
He adds, ironically: “The fact that it kills performance is seen as just an unfortunate side-effect.
“It doesn’t exist in our unit trusts. Potentially, however, it could exist [in the UK]. I am sure that some UK unit trusts have been exposed to market timing. Since it is not illegal it can be hard to notice, especially were it to be done by smaller investors.”
The highlighting of such practices, which Zitzewitz estimates cost ordinary investors 1.1 percentage points of the annual return on long- term mutual fund holdings, recently prompted Peter Fitzgerald, Republican senator for Illinois, to describe the US investment industry as “the world’s largest skimming operation”.
At a Senate hearing into abusive trading practices, Fitzgerald described America’s once-trusted mutual fund industry as a “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”.
That’s strong stuff. Spitzer — now public enemy number one for the US investment business — recently went a step further. The 45-year-old described the mutual fund industry as a “cesspool”.
Last week the regulators (Spitzer is now working alongside the SEC) claimed their first corporate scalp. The Arizona-based private bank Security Trust was shut down after being named as an intermediary that allegedly allowed Edward Stern’s Canary hedge fund to make illegal trades in shares. These trades came to light in September when Canary, without admitting any wrongdoing, agreed to pay $40 million in fines and compensation.
On 28 October, Secretary of State William Galvin and the SEC charged Boston-based Putnam Investments with doing little to prevent improper short-term trades among its international funds.
Putnam has since reached a partial settlement with the SEC over the charges, promising real reform and a clamp down on market timing trades by its own staff. Parent company Marsh & McLennan also ousted Putnam’s CEO. So far this month the firm has lost $30bn of its $280bn in assets under management. To put that in perspective it is more or less equivalent to the entire assets under management of Baillie Gifford or Aberdeen Asset Management.
David Spina, chairman and chief executive of Boston-based State Street Corporation, says: “I think it is very serious. What really happened in the US, more so than in other countries of the world, is that a whole savings and investment industry grew up outside the traditional bank and insurance markets regulations.
“The Putnams [and other major players] are independent of the universal bank model which is so dominant elsewhere in the world, so when you call into question the underpinnings, the fundamental levels of trust, I think it is extremely serious.
“There was a net inflow of money into US equity mutual funds last week. So the consumer still [trusts the system] but there will be regulatory change which is going to put pressure on the industry.”
Eliot Spitzer’s critics see him as more than just a nuisance. They accuse him of political grandstanding in a desperate bid to raise his profile as a “consumer champion” in his race to stand for the governorship of New York in 2006.
One Boston-based financial leader says: “The main argument I have with Mr Spitzer is that he is elected by a state government and the so-called universal settlement with investment banks was really dealing with a national or global industry, so I don’t think an elected official from one state should have the scope to force structural changes in what’s either a national or global market.”
“It’s become a witch hunt out there,” says another senior US-based fund manager. “It would be a real shame if the media’s widespread misreporting [of the market timing and late trading situation] tarnishes the whole fund management business.”
The executive suggested that even firms which have done nothing wrong may suffer, because of the general Salem-like atmosphere which has enveloped the industry. This is because there could easily be a general loss of trust among retail investors, or because even minor misdemeanours by one or two criminal junior employees could be found out and then “blown out of all proportion by the media”.
Fresh from his triumph over the investment banks — n which he orchestrated a “universal settlement” whereby 10 US investment banks including Citigroup and CSFB agreed to cough up more than $1.4bn in fines and other payments because of misleading research published during the dotcom bubble — Spitzer certainly feels he is onto something.
In a recent interview, Spitzer describes the findings of his latest inquiries as “remarkable”.
“You never could have predicted it. Back before we announced this, I said to some folks here, ‘This will be interesting, but there is no way it will compare in impact to last year’s investigations of the investment banks.’ I was wrong. For the 90-plus million Americans who have mutual funds, this is perhaps even more significant.”
It seems Spitzer’s investigation is only just getting started. He told The Baltimore Sun: “The problems we have seen are deeply troubling. There will be more criminal cases. There is the very good possibility that there will be criminal cases brought against entities, corporations as well as individuals.”
The biggest worry for the mutual fund companies is not necessarily the possibility of fines and having to pay compensation. It is that fund management groups will need to amend their practices, for example by pricing their units more frequently, in ways which are anyway unlikely to keep arbitrageurs out.
State Street’s Spina says: “What I am most worried about is that some academics are saying, ‘We’ll just price [mutual funds] continuously.’ As a practical matter — as an organisation which deals with price feeds on tens of thousands of prices of securities around the world — that is a very messy area. It would have to mean that [the charges for ordinary investors would rise]. Normally we don’t mind complexity, but I’m not sure continuous pricing of mutual funds is the silver bullet.
“The SEC will set a regimen in the US which will combine more frequent pricing with mandatory penalties for active trading. What Spitzer and William Donaldson [chairman] of the SEC are trying to accomplish is that they would like the fixes not to result in higher charges to the individual investor.”
It remains to be seen whether they are capable of pulling this off.
This article was published in the Sunday Herald on 30 November 2003