US Fund Scandals: What's it all about?

1 Stale unit price arbitrage
Most US fund managers price their funds at 4pm US Eastern time, when US sharemarkets close. Investors who want to buy or sell units at that price must submit their orders to their fund manager, or to an intermediary such as Charles Schwab, no later than 4pm.

When pricing units, managers use typically the closing price for each security for that day. This works reasonably well as a pricing mechanism for US-based assets. However, many non-US markets have already been closed for hours by the time the fund manager comes to price its funds.

This potentially presents savvy traders with an arbitrage opportunity. Take, for example, a day when several US firms issue bullish earnings reports during the afternoon, US time.

The US market would almost certainly rally sharply, and the smart money would bet that non-US markets would also post gains the following day.

However, the hours-old closing prices from Japan, Australia, and Europe would not reflect this important information. Effectively, a short-term trader would have the opportunity to buy $1.00 of securities for 98 or 99 cents, and then sell this position for full value during the next day. (US funds lack buy/sell spreads, although some do levy so-called ‘redemption fees’ of up to two percent on short-term trades.)

These ‘stale’ unit price arbitraging activities are probably legal, unless prohibited expressly by a fund's prospectuses, but amount effectively to transferring wealth from long-term unit holders to short-term traders.

The Attorneys General of New York and Massachusetts have brought civil fraud charges against some firms, which apparently permitted these short-term trades. A number of firms, including Janus and Banc One, appear to have allowed some investors to conduct this type of transaction.

2 Market timing within US domestic portfolios
There are also opportunities to profit from short-term trading within certain US-focused funds, especially in the small-cap area.

When the US market appreciates sharply on a given day, relatively liquid large-cap stocks often post the most dramatic gains, especially if the upward move occurs late in the day. Over succeeding days, there is often a ‘catch-up effect’, in which small-cap stocks outperform large-caps.

Some US traders have purchased units in small-cap funds to try to capture these disproportionate gains, again transferring effectively dollars from their rightful owners – the longer-term unitholders – to short-term traders.

3 Late trading
This clearly illegal practice occurs when a fund manager accepts a unit purchase order after the 4pm market close.

To take one example: large US firms frequently wait until after the market closes to issue earnings reports. If a bellweather company such as Microsoft issues a surprisingly good profit report ‘after the bell’, the market is likely to rise the next day. By submitting a purchase order for units at 6 pm, and getting the 4 pm price, a trader may again buy $1.00 of units for 98 or 99 cents. And again, those gains come out of the pockets of long-term investors.

Bank of America is among the fund managers, which have allegedly accepted – or even encouraged – this type of behaviour.

4 Trading by insiders
This occurs when a portfolio manager or other fund manager employee benefits from stale unit price arbitrage or short-term trading within US domestic portfolios.

An insider taking advantage of stale unit prices raises a number of concerns. Firstly, it would be a clear violation of fiduciary duties. Secondly, insiders have access to important information not available even to short-term traders outside the fund company. Specifically, insiders are aware of the fund manager’s pricing policies.

On days when the US market rises or falls substantially, many managers (such as Fidelity) use a technique called ‘fair-value pricing’ to estimate the value of international portfolios as of 4 pm US Eastern time.

Taking into account the changes in the value of the US market, the prices of foreign securities listed in the US, and the values of ETFs which track foreign markets, fund managers may use this fair-value pricing to determine a more accurate estimated value for international funds’ units.

This removes the arbitrage opportunity for short-term traders.

Company insiders are often in a position to know the in-house policies on the use of this fair-value pricing. For example, most fund managers use typically fair-value pricing only on days when the US market rises or falls more than a set amount – say, 1.5 or 2%. So the insiders know exactly when they can – and cannot – benefit from stale unit pricing. Among those who allegedly exploited longer-term unit holders in this way are Dick Strong, the founder and (until recently) chief executive of Strong Capital, and several since-fired portfolio managers at Putnam.

5 Trading in retirement accounts
As it turns out, trade union members are capable of being just as shrewd as hedge fund operators and company insiders when it comes to manipulating managed funds. Another of the ‘scandals’ is the allegation that members of a boilermakers’ union – participants in a Putnam-administered 401(k) plan (roughly equivalent to corporate superannuation in Australia and New Zealand) – discovered that they could benefit from stale unit price arbitrage.

Between 2000 and 2003 – one of the worst bear markets in US history – 10 members of the union allegedly used short-term trades to post combined profits of $2 million.

Again, those terrific results came at the expense of the long-term investors in the fund.

While many fund managers levy up to two percent redemption fees on short-term trades (defined usually as those held for 90 days or less), in an effort to discourage market timing, those redemption fees are typically waived on 401(k) accounts, in part because they are difficult to administer.

More firms, including Putnam, are now charging redemption fees on assets held in 401(k) accounts. These fees are paid to the affected fund, rather than to the fund manager.

6 Front running
In at least a few cases, fund managers appear to have made nearly real-time disclosures of portfolio holdings which enabled outside parties to engage in a practice called ‘front running’.

In this situation, a hedge fund, for example, may be able to see which stocks a fund manager has bought – and may be likely to continue buying. The hedge fund then purchases those same stocks for its own account, hoping that the fund manager’s continued buying will push up the share price. The hedge fund’s purchases would tend to push up the price the managed fund must pay for its shares, effectively costing the fund’s unitholders money.

Why would a fund manager make such a deal? In the case of the founders of one US firm, PBHG, it appears that they invested money in a hedge fund, then allowed it to ‘front run’ the portfolios of several PBHG funds. US regulators have therefore alleged that company insiders were gaining indirectly at the expense of the unitholders whose interests the fund company staff were supposed to protect.

7 Questionable fund sales practices
An entire book could be written on this topic, but it’s clear that the SEC and the New York Attorney General are both taking a close look at sales practices which may prompt financial advisers to place financial self-interest ahead of their obligations as fiduciaries to their clients.

For example, Morgan Stanley recently agreed to pay the SEC US$50 million to settle a complaint over incentives Morgan Stanley gave advisers to promote particular funds. Specifically, advisers received higher compensation for promoting in-house funds, as well as those of a select list of firms which had paid Morgan Stanley large sums of money to be part of its so-called ‘Partners Program’.

These incentives were not disclosed to investors in Morgan Stanley funds.

Scope of the problems
It’s too early to place a dollar value on the amount of investors’ alleged losses, but we believe the figures – and the scope of the investigation and remedies – will be substantial.

Alliance Capital Management announced recently that it would set aside US$180 million to pay market timing-related regulatory fines, legal costs, and restitution to unitholders harmed by short-term trading. Of that amount, an estimated half, or US$90 million, will be paid to US unitholders.

Clearly, then, for some individual fund managers, the amounts will be large.

Moreover, these alleged improprieties are affecting a large percentage of the US funds management industry. The SEC recently surveyed 88 of the largest US fund managers, and 44 of these admitted that they had established short-term trading relationships with outside parties.

It’s entirely conceivable that this figure will grow, as more fund managers conduct in-house investigations to determine whether employees traded for their own accounts, or whether a rogue employee discovered a way to circumvent in-house compliance systems and establish trading relationships with outside parties.

At this point, one cannot be sure which areas will attract the regulators’ scrutiny. According to press reports, New York Attorney General Eliot Spitzer is concerned about the gap between management fees on retail compared with institutional (wholesale) products; various incentives for advisers to promote the products of a particular fund manager; ‘soft dollar’ arrangements between fund managers and Wall Street brokerages; and so forth.

Many practices which have been accepted in the funds management industry for decades are now coming under heavy scrutiny.

In Part Two of this article Implications for Investors Down Under Morningstar examines what the implications of this market timing scandal are for Australian and New Zealand investors.

Scott Cooley is the chief executive of Morningstar in Australia and New Zealand.

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