In the fall of 2003, newspaper headlines blaringly announced the arrival of the mutual fund market-timing scandals. Now the case is ending quietly—very quietly—as fund shareholders receive payments designed to compensate for their losses. In the first batch of checks, 600,000 investors in Putnam funds will receive a total of $40 million. During the next six months, another $110 million will go to Putnam shareholders. Around the same time, Janus shareholders should receive $100 million.
What impact did the market-timing scandal have on the fund industry? Some prominent executives lost their jobs, and investors pulled billions of dollars from fund companies—such as Putnam and Janus—that were accused of wrongdoing. But no big reforms have emerged—none were necessary to correct what was always a limited problem. Hounded by the ambitious then-New York Attorney General Eliot Spitzer and other critics, fund companies installed technology that spots rapid trading, and market timers moved on to other games.
At a time when reckless actions in mortgage markets have erased billions of dollars of wealth, the fund scandals now seem like small potatoes. While it was surely wrong for fund companies to allow speculative trading by hedge funds, the damage to shareholders was probably tiny or nonexistent.
To appreciate the extent of the losses, recall that the market-timing scandals centered around a form of rapid trading. A speculator seeking to profit from the strategy would wait for a day when the S&P 500 was rising sharply. Just before the 4 p.m. market close in New York, the speculator would buy shares in an Asian fund. Although the fund was based in the U.S., it would hold stocks that traded in Asian markets, which were closed for the night. The speculator bet that the Asian stocks would rise the next day in response to the good mood on Wall Street.
In his complaint, Spitzer said that the speculator would profit the next day when the Asia stocks climbed. But other investors in the fund would be hurt. According to the Spitzer theory, the fund would take hours or days to invest the speculator’s cash. In the meantime, the cash would dilute the fund portfolio, reducing the gains that occurred when Asian stock rose.
Spitzer figured that the speculators were brilliant and always chose the right days to invest. However, it is safe to assume that the smart guys sometimes got it wrong. When that happened—and Asian stocks dropped—the cash from the speculators would cushion the downturn and reduce the losses of other shareholders in the funds.
To figure out how much a shareholder lost, regulators had to determine what days rapid trading occurred and which shareholders were hurt. That was an impossible order, so fund companies were instructed to hire college professors or other outside experts. Putnam retained Peter Tufano, a professor at Harvard business school, who dutifully attempted to estimate the losses.
In his final report, Tufano conceded that his figures could be all wrong. He also concluded that the worst damage to shareholders occurred after Spitzer staged his press conference and alerted the public about the menace. Frightened about the speculators, investors began dumping their funds. That forced portfolio managers to raise cash by selling stocks quickly, a process that can magnify losses. In some cases, the losses due to panic selling were substantial, Tufano concluded. For example, the professor said that shareholders in Putnam Vista lost $291,727 due to market timing and $1,032,000 from selling by shareholders that occurred after the scandal became a public issue.
Of course, it is impossible to know whether the professor’s theory is correct. But if he is right, then it appears that regulators should have stopped market timing by quietly issuing some rules—not by staging noisy press conferences that led to panic selling.