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To Define a Theft

More than two and a half years after the market-timing scandal, investors have yet to recieve a dime in restitution

The typical television crime show presents simple plots. The bad guys rob a bank and are soon caught. The cops return the money to the rightful owner. But in real life, restitution of ill-gotten gains can prove to be a far more vexing process. Take the market timing of mutual funds: More than two-and-a-half years after supercop Eliot Spitzer announced the fund “heist,” it is still not clear how much money was taken. Shareholders of implicated fund companies, such as Putnam and Janus, have yet to receive a penny of compensation.

When will the restitution begin to flow? Putnam, the company that seems closest to putting checks in the mail, says shareholders should begin receiving restitution forms to fill out this summer. But it could take months — or years — before they see the return mail. “There are a lot of questions to be answered,” says Tamar Frankel, professor of law at Boston University. “If one investor has 100 shares and another has 100,000, you have to figure out how to pay each of them fairly.” And apparently that isn't as easy as it sounds.

A Complex Problem

From the beginning, the fund scandal frustrated those who sought a speedy resolution. The first problem was to figure out who did what. Regulators could see that some fund companies were playing unsavory games with shareholders' cash, but it was not clear how to quantify the harm and how to make the victims whole. If the fund heist had been a television drama, victims would have screamed for the NYPD. Instead, real-life regulators and fund companies hired college professors and other consultants, people who specialize in developing theories to explain complicated events. The task of the consultants was to figure out what was lost and who should receive compensation. How, as in fund-timing, do you calculate the harm to investors who did not see their own shares hurt — but didn't get the breaks the timing customers received?

Among the consultants is Peter Tufano, a distinguished professor at Harvard Business School, who was hired by Putnam. Tufano found that market timing had cost Putnam shareholders $4.4 million, an estimate that was accepted — but not officially endorsed as the only correct answer — by the SEC. In his report, Tufano noted that the exact figure was not clear, and, in some instances, shareholders may have actually made money at the expense of market timers. The greatest damage came after New York Attorney General Eliot Spitzer publicly announced the trouble, says Tufano. Why? Upon learning of the questionable trading activity, shareholders panicked and dumped their Putnam shares, a process that produced an estimated $48.5 million in losses for shareholders who remained with the fund.

To appreciate the complexity faced by Tufano and other consultants, recall how speculators seek to profit from market timing. Say the S&P is rising sharply today. Before the market closes at 4 p.m., a New York speculator buys shares in an Asian mutual fund that trades on Wall Street. Although the fund is in New York, stocks in the portfolio are listed on Asian exchanges, which are closed for the night. Because the values of the Asian stocks do not yet reflect the optimism in New York, the share prices are said to be stale (in this case, probably too low). The speculator buys the stale Asian fund, figuring that it will rise in a few hours, and he can pocket an easy profit.

According to Spitzer, the speculator pours cash into the fund that can't be invested in stocks for hours or days. That raises the amount of cash in the portfolio and dilutes any rise achieved by the stock holdings. When the fund rises after the Asian markets open, long-term shareholders will achieve smaller gains than they should have.

The Spitzer analysis assumes that the speculators always get it right. But in all likelihood, the traders sometimes miss the mark, and the Asian stocks drop. When that happens, the extra cash in the fund reduces the loss, benefiting shareholders. With so much activity, it is hard to know what the real impact of market timing may be.

Reforming At A Glacial Pace

For all the uncertainties, the SEC continues battling the problem. After the scandal broke, the regulator promised tough moves to stop the questionable trading. But so far, the pace of change has been slow. “It seemed certain that the SEC would figure out rules to crack down on market timing,” says Russel Kinnel, fund research director of Morningstar. “But they really haven't done much.”

The SEC proposed redemption fees that would sock rapid traders with hefty penalties when they sold. That would take the profits out of market timing. But the industry protested, arguing that the penalties would harm innocent investors. The SEC backed down and presented rules allowing funds to impose voluntary redemption fees. Another proposal would have instituted a so-called hard close. That would require all trades to be completed by 4 p.m. Eastern time. But West Coast brokers screamed that their clients wouldn't have time to complete trades. The complaints stopped the SEC, and no rule on a hard close has appeared. One rule that has survived challenges requires fund boards to have independent chairmen. Such outsiders seemed more likely to stand up for shareholders. Perhaps over the long term, the independent chairmen will have an impact, but so far it is hard to notice many differences.

Morningstar's Kinnel says that the fund companies themselves have made some of the most important changes. Seeking to satisfy regulators and win back investors, fund companies like Alliance and Putnam, have fired employees who were involved in the troubles. More importantly, the companies have altered their bonus systems. “Too many companies had perverse incentive systems that rewarded hot short-term performance and didn't provide any penalties for long-term problems,” says Kinnel.

Some companies gave bonuses to salesmen based on one year's sales — not on whether investors stayed with the fund for the long term. Now companies look to reward salesmen who get and keep assets for longer periods, such as three years. During the 1990s bull market, Janus gave big bonuses to portfolio managers who achieved performances in the top 10 percent of their categories for one year. If the managers stumbled the next year, there was no penalty. The whole scheme encouraged managers to swing for the fences — and not worry about striking out. Now the Janus bonus system rewards managers who produce solid three-year returns.

Yesterday's Yawn

For many investors, the fund scandals now seem to be ancient history. But not everyone has forgotten. Since word broke of the market timing, funds caught in the scandals have suffered outflows as shareholders jumped overboard. The losses continue today, but at a reduced rate. The problem is most pronounced at growth-stock shops, companies that faced bad newspaper headlines and big losses after the market downturn that began in 2000.

In 2004, Putnam lost $26.7 billion in assets, according to Financial Research Corporation. The outflow only slowed to $20 billion in 2005. Janus lost $18 billion in 2004 and $10 billion in 2005, while AIM lost $14 billion in 2004 and $12 billion in 2005. Much of the losses can be attributed to advisors steering away from potential problems. “Advisors have long memories, and they don't want to be part of any trouble,” says John Sterba, president of Investment Management Advisors, a registered investment advisor in New York.

While investors continue fleeing dangers, they may be avoiding a problem that no longer exists. Regulators see little evidence that market timing is continuing. Hedge funds that once practiced the craft have moved on to richer fields. Says Andrew Stoltmann, a securities lawyer in Chicago, “Market timing may appear again in a few years, but for the time being it seems to have disappeared.”

Funds With Big Sales — and Big Withdrawals

Since the fund scandals broke, funds with clean reputations and solid returns have attracted new assets — while companies that were attacked by regulators suffered outflows.

Company name Net Inflows of assets in billions
2005 2004
American Funds $78.8 $90.5
Vanguard Group 45.5 51.1
PIMCO Funds 21.8 10.7
Putnam Investments (20.9) (26.7)
AIM Distributors (12.0) (14.1)
Janus Capital (10.3) (18.5)
Source: Financial Research Corporation
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