Amid fund probes, investors need to craft own strategies

By Chuck Jaffe, Globe Correspondent, 10/23/2003

First it was mutual fund firms allowing illegal trading by hedge funds, and allowing market-timing trades by big institutional investors.

Now, it is mutual funds allowing market-timing trades by some individuals, but not all of their shareholders.

That scandal has moved to the business pages, as Massachusetts Secretary of the Commonwealth William F. Galvin prepares to file a civil complaint against Putnam Investments, the nation's fifth-largest mutual fund firm.

Those charges, according to sources close to the Commonwealth's investigation, center on investors in some large retirement plans allegedly being allowed to make rapid-fire trades in Putnam funds that did not allow that kind of market-timing activity by other shareholders.

Putnam, a part of the Marsh & McLennan Cos., issued a statement denying any "improper behavior related to market timing within our 401(k) client base."

The Putnam matter showcases the next wrinkle investors are likely to see in the ever-expanding federal and state investigations of trading activity by mutual funds. It marks the first time a fund firm actually has to stare down civil charges borne of these investigations. To date, fund firms have been investigated in cases against hedge funds or have had executives tagged with charges.

The trouble being looked at with Putnam revolves around rules in place at its funds, specifically those prohibiting market timing. Timing trades are not illegal, but they can be costly to buy-and-hold investors. Many fund companies try to stop them by implementing short-term trading fees -- where an investor who sells the fund within a short period after buying it must pay a fee -- or by simply freezing an account's trading privileges once they see an investor making several quick round-trip trades.

The case Massachusetts regulators reportedly are preparing -- and they've been working with Securities and Exchange Commission officials on it -- suggests that some of Putnam's 401(k) contracts allowed plan investors to make timed trades despite prospectus rules that prohibited ordinary customers from pursuing the same strategy.

In the investigations into trading activity at Janus, Strong, NationsFunds, and One Group, the central issue has been "discretionary trading arrangements," where the fund firms allowed big institutions to make timed trades, and were rewarded for breaking the rules by having big slugs of money put into their bond funds for a long stretch of time.

In Putnam's case it appears regulators will maintain that Putnam made timing a selling point in luring a few big retirement plan sponsors.

Putnam's statement denying wrongdoing did note three retirement-plan clients where timed trades occurred and the action taken to stop the activity. Putnam noted that it "faced difficulties curbing excessive trading" in one of those plans, troubles that may have been caused by its contract with the retirement plan sponsors.

Putnam officials did not return calls seeking comment on the matter.

If you're the average investor, you're still wondering if this is a big deal.

But investigators are prepared to allege, as reported in the Globe yesterday, that individual investors in these plans made hundreds of trades valued at millions of dollars. "Each of these cases is a little different, and investors can't make a snap judgment based on any of them," says Eric Kobren, who runs Kobren Insight Management in Wellesley. "I don't think that in any of these cases we will come away saying `Investors were ripped off for half of their profits,' and I don't think anyone is going to say we should condone bad behavior.

"But in the end what we will want to know is `Who knew, when did they know it, and did they try to put a stop to it?' "

If you own funds directly affected by the allegations, moving out is a matter of principle (as is looking to join a class-action suit). If you don't own funds with a firm implicated by scandal, you can simply stay away. If you own funds with the firms under investigation, or perhaps the firms to be charged next, that's where the decision gets murky. Walter S. Frank, chief economist at Moneyletter newsletter, says he has not shied away from the affected fund firms.

"If the fund is performing, my only response is to ignore it," says Frank. "I don't want to be giving anything away in performance, but if the fund is performing well, I'm not making a change if they're not affected."

The biggest threat to the funds at the firms impacted by scandal is that investors flee. No one is forecasting a run on the funds; while money has been pulled from the firms already tainted, it hasn't been a strategy-changing flood.

In theory, a fund that sees significant redemptions would sell stocks across its portfolio to meet the bailout. By dumping positions in its stocks, the fund drives those prices down and the remaining investors can get hurt. It's the reverse of what happens when a fund gets hot, draws millions and pours that cash into stocks it already owns, pumping those stocks up higher.

But those situations generally require a fund to be a big player in smaller issues, which would not describe most of the funds tainted by the current allegations.

Some observers go a step further than Frank, and believe the affected fund companies will be the place to invest because outstanding performance will be the only way to be exonerated in the court of public opinion.

And for investors who haven't been drawn into the scandal yet, don't believe you are out of the woods.

"This is going to be a long, drawn-out affair and we're just at the beginning of it," says Kobren, who runs mutual funds that invest in other funds. "Six months from now, we'll be talking about the same issues, but we'll be putting the names of new fund companies in there."

Chuck Jaffe is senior columnist for CBS MarketWatch. He can be reached at jaffe@marketwatch

.com or Box 70, Cohasset, MA 02025-0070.