When the mutual fund scandals broke in September 2003, New York Attorney General Eliot Spitzer and other politicians described the misdeeds in black-and-white terms. According to the original story line, the villains were mainly mutual funds who lifted billions of dollars from the wallets of shareholders. The industry needed to invest heavily in implementing new rules and procedures that would stop the thefts.
Now, two years into the legal actions, the saga has begun to appear murkier.
Legal documents from the recent case against Canadian Imperial Bank of Commerce indicate that many mutual fund executives acted responsibly, working against the rapid trading known as market timing. Documents suggest that it is hard to tell how much shareholders lost. In fact, some innocent shareholders probably made money from the market-timing incidents. Altogether, the list of unanswered questions is long.
In the early days of the scandal, headline writers emphasized the role of mutual funds, pointing the finger at big names, including Janus, Strong and PBHG. While some fund executives acted unethically, it now appears that hedge funds and brokers may have played primary roles. Consider the recent settlement involving brokers from Canadian Imperial Bank of Commerce. CIBC agreed to $125 million in penalties and disgorgements but didn’t admit guilt. Complaints from the offices of Spitzer and the SEC sometimes paint mutual funds as victims of CIBC.
“Many mutual funds honored their fiduciary obligations,” the attorney general’s complaint notes.
In other places, the complaint sounds downright sympathetic to the complex task funds face in stopping questionable trades.
Representing hedge funds, CIBC began making a series of rapid trades. But this was a violation of trading rules at some companies, and the mutual funds soon caught on. By the end of 1999, more than 10 mutual fund companies had sent a total of 40 communications telling the brokers to stop the rapid trading.
To keep trading, the CIBC brokers decided to “fly under the radar.” In some cases, they changed the names of the accounts or the identification numbers of registered reps. One strategy was to simply open many accounts, making it hard to trace who was trading.
Spitzer has contended that a fund cannot permit rapid trading if the prospectus frowns on the practice. But in his trial against former Bank of America broker Theodore Sihpol, the attorney general lost. The jury appeared unclear about what the crime was and why more people weren’t being prosecuted.
“There are no clear definitions of ‘market timing’ in regulations or in legislation,” writes Peter Tufano, a professor at Harvard Business School, who has been hired by Putnam Investments to help the fund company assess how much shareholders lost.
In recent months, some academics have estimated that the typical mutual fund shareholder lost only pennies from market timing. But it now appears possible that the total is less. In all likelihood, most fund shareholders will never receive a check in the mail as compensation. Although about $2 billion now sits in accounts earmarked for compensating shareholders, it could be months or years before the first penny is paid out.
The delays are caused by the stick problem of figuring out which shareholders lost money. Based on the newspaper headlines, you would think that economists could tally the losses by simply counting the number of illegal acts and totaling the criminals’ winnings. But the process is not so clear.
Say a speculator in New York sees that stocks have climbed in the U.S. Anticipating that Asian stocks will soon rise, he buys a China fund while markets in that country are closed for the night. If Chinese stocks rise the next day, the speculator makes an easy profit. The problem is that the fund’s portfolio manager may not be able to invest the speculator’s cash for days. The speculator may make a quick 2 percent, but the fund suffers because it is holding excess cash that drags down returns. How much do the shareholders lose from dilution? That is hard to say.
What makes it especially difficult to estimate is that there are cases where the speculator gets it wrong and stocks fall. In his report for Putnam, Tufano calls these backfires “anti-dilution” and notes that the speculator’s extra cash sitting in the portfolio sometimes “provides a benefit to fund shareholders.” In other words, some “victims” of market timing actually made money from the practice.
Undaunted, Tufano has soldiered on, not talking to any traders and instead using “statistical techniques to identify potential market-timing transactions.” He looked at cases of rapid trading and came up with estimates of market-timing losses by Putnam shareholders. The numbers are generally relatively small. For Putnam Voyager, a fund with more than $24 billion in assets in 1999, the market-timing losses were estimated at $335. At Putnam Vista, which had more than $5 billion in assets, the losses were put at $753.
Spitzer and others have called for substantial regulations. The SEC proposed mandatory redemption fees. In some proposals, a trader who bought a fund and then sold it quickly would have to pay a 2 percent fee. But the industry howled in protest. The fees would be expensive to implement and might hit innocent shareholders, critics charged. In response to the complaints, the SEC backed down, suggesting voluntary redemption fees. While redemption fees pose complications, there could be other easy solutions.
Working to police itself, Putnam barred rapid trading by portfolio managers and clients. Portfolio managers must now make all their trades through Putnam and not go to another firm where it may be easy to disguise the market timing. This straightforward approach appears to be working. According to SEC sources, Putnam’s market-timing problem has essentially vanished. That suggests what may be the simplest solution. To stop market timing, the industry doesn’t require more regulations; fund companies only need to monitor trading and stop speculators as soon as they appear.