TCS Daily

Shocking and Sickening

By James K. Glassman - November 14, 2003 12:00 AM

As the scandal in the mutual fund industry spreads, the case for hanging on to funds that engaged in unfair or illegal practices diminishes -- and, in some instances, vanishes into thin air.


At Putnam Investments, Lawrence J. Lasser, the chief executive, resigned after securities regulators sued his firm for fraud. Putnam, according to the charges, did little to stop market-timing abuses -- not only by big outside investors but also by its own managers.


At Strong Investments, Richard S. Strong, the chairman and founder, resigned after allegations that he himself executed improper trades in his company's funds.


At Fred Alger Management, James P. Connelly Jr., the head of fund sales, settled civil charges with the Securities and Exchange Commission for allowing market timing, and then pleaded guilty to obstructing an investigation by New York Attorney General Eliot L. Spitzer, who charged that Connelly asked subordinates to delete potentially incriminating e-mails.


My advice: It's time to dump Putnam, Strong and Alger funds, unless you have a very good reason to keep them, such as avoiding a big tax bill or wanting to hold on to a fund that has been a superb performer. All three of the firms are making changes, so if you are the forgiving sort, you may want to wait. But, in my view, it is reckless to entrust your money to institutions that have proved rotten at the top, no matter what their intentions for the future.


However, the abuses and crimes of a few rogue managers, acting without the knowledge of their bosses, can be excused. That's why I am not ready to pull the trigger just now on the growing list of other firms implicated in the scandal: Alliance, Bank of America (Nations Funds), Bank One (One Group), Federated, Janus and now, according to The Washington Post last Thursday, Invesco.


Morningstar, the respected research firm that specializes in mutual funds, has a slightly different view. In an article on its Web site ( last Tuesday, Russel Kinnel, Morningstar's director of fund analysis, said that investors should "consider selling" Alger, Nations, One Group, Janus and Strong. "Given the kind of behavior that evidently went on at these firms, we don't think they clear the minimum threshold for corporate governance."


As for Putnam, Morningstar advises you to "hold off on sending new monies." The reason for not selling outright is that the firm has taken significant measures to clean up its act. On Oct. 24, Putnam admitted that six of its investment professionals -- five of them managers of fund portfolios -- had engaged in market timing, that is, short-term trading to take advantage of prices on foreign markets.


Market timing of mutual funds is not illegal, but, because it hurts their long-term shareholders, most funds officially discourage it. The abuse comes when a fund says publicly that it will deter market timing and then turns around and assists big clients to make profits by using the practice.


In a review of 88 fund companies, the SEC found that half allowed at least one large investor to engage in market timing. Why? The obvious reason is to bring in new business from the timers. By doing so, however, a fund is treating its small investors like second-class citizens while winking when the big boys cheat -- or even helping them do so.


Strong and Putnam went a step further. They did it themselves.


Strong's founder, according to reports, made market-timing trades from his own account and those of his family and friends, and made $600,000 in profit. Putnam portfolio managers also engaged in market timing. Worse, Putnam had known about the abuses since 2000 but, according to Morningstar, "did nothing but tell those involved... to cut it out." That's a serious betrayal of trust; I wouldn't want my cash invested by such a firm.


In the most general sense, market timing means trying to guess which way stock prices will go and then buying and selling to take advantage of those hunches. Market timing is a curse for most investors, who, for example, tend to bail out of stocks when prices fall, thinking that they will fall further. It's the opposite of the kind of investing that I advocate: buying and holding for the long term and not trying to anticipate what will happen in the short.


But the market-timing abuses cited by regulators are different. Rarely do they involve guesswork.


Late trading, one of the abuses, is against the law. At the implicated firms -- Alger, Nations and Federated -- late-trading bandits, who bought funds at, say, 5 p.m. Tuesday were able to pay the 4 p.m. Tuesday price, not the 4 p.m. Wednesday price. If major stock-moving events happened shortly after the 4 p.m. Tuesday close in the U.S. markets, then the late trader can profit.


In a second kind of abuse, market timers take advantage of the fact that Asian and European markets close earlier than U.S. markets.


Consider this scenario. Nearly all U.S. mutual funds set their prices once a day, at 4 p.m. If you buy shares of a mutual fund any time between 4 p.m. Tuesday and 4 p.m. Wednesday, you pay the 4 p.m. Wednesday price. But by the 4 p.m. U.S. close, Asian markets have been closed since the night before, since 2 a.m. New York time. So the prices of Asian stocks in U.S. mutual fund portfolios are "stale." That is, they were set 14 hours before the U.S. close. A lot can happen in 14 hours.


An investor, knowing that good news has occurred for Asian stocks after the 2 a.m. close, can buy an international-stock mutual fund with lots of Asian holdings at a depressed, "stale" price (because the Asian markets won't reopen until after the New York market is closed), then sell it a day later for a quick profit.


How does this hurt other shareholders? First, as Paul G. Haaga Jr., chairman of the Investment Company Institute (ICI), said in testimony before a House committee on Tuesday, "frequent trading may compel portfolio managers either to hold excess cash or to sell holdings at inopportune times in order to meet redemptions." It can also boost brokerage costs that get passed on to all shareholders. Second, market timing dilutes the value of the holdings of the fund's shareholders.


This concept is hard to grasp, I will admit. Think, however, of a small mutual fund with only 20 investors. Each owns $10 worth of shares in the fund, so the entire fund has stocks worth $200. Now imagine that a market timer who knows that shares will rise the next day invests another $10.


The fund's manager can't put the $10 into stocks quickly enough, so the fund's assets are $200 in stocks and $10 in cash. The next day, stocks do indeed rise -- say, by 10 percent. Now, the fund's stocks are worth $220 and, with its cash of $10, its total assets are $230. So, the gain for the fund's shareholders isn't a full 10 percent but, instead, 9.5 percent ($230 - $210 = $20 / $210 = 0.095).


An article in the Wall Street Journal describing this process quotes Jason T. Greene, an associate professor of finance at Georgia State University: "The cash dilutes the positive returns to the fund's other investors."


Spitzer, who first uncovered the violations in a case involving a hedge fund called Canary Capital, uses an apt metaphor: Late trading is like "betting on a horse race after the horses have crossed the finish line."


In hearings last week, some members of Congress described mutual fund abuses as "skimming" -- in other words, robbing millions of shareholders of amounts too small to be easily noticed, like siphoning pennies from a vast number of bank accounts.


But are the amounts in the scandal really so small?


When I asked a top official of the ICI, the main trade group for the industry, that question on Wednesday, he said he simply did not know. He emphasized that no matter how small the profits, the miscreant firms betrayed the trust of their investors. True, but the question of how much is important.


The top expert on the subject is probably Eric Zitzewitz, a young assistant professor of strategic management at the Stanford Graduate School of Business. Zitzewitz has been studying market timing and late trading for much longer than most of us even knew they existed. A study he completed in June 2002 focused on international-stock funds, where, he concluded, "the cost to long-term shareholders is as much as 2 percent annually."


Two percent! That is a huge number when you consider that the average stock mutual fund returns about 10 percent annually.


Late trading, while a more serious offense, seems to hurt investors far less. In a summary of a separate paper, Zitzewitz writes, "I find annual long-term shareholders' losses due to late trading of about 5 basis points in international equity funds and 0.6 basis points in domestic equity funds." One basis point is one-one-hundredth of a percentage point, so these figures are less disturbing.


Overall, Zitzewitz estimates annual losses at about $5 billion. Total assets for all mutual funds are $7 trillion, so the average loss to the typical investor in the average fund is about 0.1 percent, or 10 cents per $1,000. But that figure, too, is misleading because it includes funds -- including money-markets and large-cap index funds -- where it is highly unlikely that any shenanigans occurred.


Again, no one really knows how badly individual investors have been hurt. Zitzewitz says that the most dangerous funds are those that focus on international stocks, followed by small-cap stocks and high-yield and convertible bonds. He also found that the funds that do the best job protecting their shareholders are those with the lowest expense ratios and fewest insiders on their boards, "suggesting that agency problems may be the root cause of the arbitrage problem."


Translated from economic jargon, this phrase means that firms with the most consumer-friendly fees and the best corporate governance are the safest. It is no coincidence, then, that the most respected of the giant fund families -- including Fidelity, Vanguard, T. Rowe Price and American Funds -- have been untainted by scandal.


The amounts that have been skimmed, however, are not trivial, and I am beginning to wonder whether market timing and late trading explain one of the deepest mysteries of investing.


In the first paragraph of his classic 1985 book, "Winning the Loser's Game," Charles Ellis writes, "Contrary to their often articulated goal of outperforming the market averages, the nation's professional investment managers are not beating the market; the market is beating them."


The most prominent of these managers are the allegedly smart folks who run mutual funds. But, as Ellis and others have noted, the average human-managed mutual fund fails to beat the benchmark Standard & Poor's 500-stock index. Ellis, in the most recent edition of his book, shows that the S&P outperformed the majority of funds in 18 of the 27 years from 1970 to 1996 -- or exactly two-thirds of the time.


Why? Ellis cites the expenses that funds charge. But those costs may not be the whole story. You would expect that a mutual fund manager -- an earnest person with large pecuniary incentives to devote time and talent to make good decisions -- could produce returns that would overcome the bite taken by expenses.


The mystery is the poor performance of such managers. In the past, my explanation for this puzzle was that fund managers are just not very good stock pickers -- perhaps because they were driven by perverse incentives, such as the need to produce strong short-term profits or to look busy by continually turning over their portfolios.


This week, however, something more sinister dawned on me. Maybe the reason funds don't do well is that they cheat.


Not all of them, of course. And not very much. But enough to cause funds to underperform the averages on a shockingly consistent basis. The average annual expense ratio for a no-load general-stock mutual fund is about 1.5 percent. Let's say that trading and market timing add 0.5 percent (again, just a guess). That two-percentage-point bite is extremely difficult to overcome with good stock selection.


So what should investors do? Seek funds from reputable firms that charge low expenses. Seek funds run by low-key, long-term managers. Don't chase short-term performance.


Also, don't panic. Mutual funds serve an important purpose. They provide diversification, bookkeeping and, yes, in some cases, excellent stock selection. But expand your horizons. A few weeks ago, I wrote about exchange-traded funds (ETFs), which are priced not once a day but continually, according to supply and demand -- just like an individual stock -- so there is no threat from market timing or late trading. ETFs mimic indexes, such as the S&P 500 or the Nasdaq 100.


Next week, I will examine closed-end funds, which are similar to ETFs but hold portfolios chosen by human managers.


The mutual fund scandals are shocking and sickening, but the industry is reforming itself -- and there are lots of alternatives.


Meanwhile, Sheldon Jacobs, who edits one of my favorite mutual fund newsletters, the No-Load Fund Investor (, lists as best buys many, many funds from firms not caught up in the scandals. Among the more intriguing: Fidelity Growth & Income II (FGRTX), Longleaf Partners International (LLINX), Legg Mason Opportunity Trust (LMOPX), T. Rowe Price Mid-Cap Growth (RPMGX), Neuberger Berman Guardian (NGUAX) and Vanguard Total Stock Market Index (VTSMX). So don't despair.


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