Trading a 'spotless' past for scandal sheet
The former Securities and Exchange Commission chairman, Harvey Pitt, said last week that the mutual fund industry was so busy touting its 80-year history of no big scandals that it may have stopped looking for one.
"That long record may have become an excuse for being complacent," Pitt said. "Claims that there have never been a major scandal are totally beside the point if they stopped looking hard for what could happen next."
Well, everyone is looking hard now, in light of New York Attorney General Eliot Spitzer's complaint against a hedge fund and four big fund complexes that allegedly made deals helping big customers at the expense of the little guy.
Rooting around the fund industry in the past week has given me sneaking suspicions of what could happen next in allegations of fund wrongdoing.
I'd love to be wrong about my hunches, because ordinary individuals would be harmed by these actions, and I have no inside knowledge of pending litigation or specific instances of the issues I foresee.
But as I read the fund business now, I can't help but envision the following as tomorrow's headlines:
Fund firms under fire for giving current portfolio data to traders, who then made moves ahead of the fund.
For years, consumer advocates have complained that they can't get information on what a fund really owns. Current rules require disclosure to shareholders only twice a year. The data are old by the time they reach investors. In recent years, many firms have stepped up disclosure, giving monthly portfolio updates, though sometimes only of top holdings. Investors and some regulators have pushed for more.
But while investors are bereft of portfolio data, fund firms have routinely provided more regular updates for hedge funds, big institutional investors and, data-tracking firms such as Morningstar, Lipper, and Value Line.
Recipients sign confidentiality agreements, so they can see the portfolio and evaluate it without disclosing the fund's actual contents.
But buried in Spitzer's complaint against Canary Capital Partners -- the hedge fund that profited from being allowed to buy into funds after trading was closed -- is an allegation that to profit from its illegal trades, Canary "first needed to determine the exact portfolio make-up of a target mutual fund. Mutual fund managers were happy to provide this information . . ."
We're talking portfolio data that were fresh as spring daisies, not the slightly stale stuff that normally goes to the data-trackers and big clients or the moldy garbage sent to individual investors.
It's a short stretch to move from "Here's our recent portfolio" to "Here's our current portfolio," particularly if the client asking for the info is willing to park a lot of money in a bond or money market fund for the foreseeable future.
Armed with a fund's portfolio virtually as it changes, a trader can effectively move money around to buy in just before the fund does, with the fund firm's purchase making the trader richer. The front-running trades drive up the cost the fund pays for the shares, thereby hurting the fund's shareholders.
Trading firms used pricing formulas against funds.
Some funds, particularly those that buy illiquid small-company stocks or paper like municipal bonds, can't just look at the market and add up the value of their holdings each day. Instead, they use a pricing formula or matrix to calculate the fund's daily price. In funds that use these pricing models, there can be times when a trader believes a fund is selling at a slight discount or premium to net asset value.
That's not to say the system is rigged, it's just that no model is going to come up with the perfect value on thinly traded securities -- issues that may not have had a fresh trade on which to be priced for days or months -- each and every day.
It only becomes a big deal if someone knows the formula and can profit from those occasional pricing anomalies. It would also be nearly impossible to trace and prove; if big members of the fund industry were willing to engage in the chicanery described in Spitzer's complaint, you have to figure someone is up to more nefarious stuff.
More late-trading allegations leveled against fund firms.
The one part of Spitzer's case that is most damning is that the hedge fund was allowed to make after-hours trades, something that is clearly illegal, and that every good citizen in the fund industry is screaming about. Thus far, everyone has said late trading was something of a freak incident, while the lesser allegations in the Spitzer complaint were far more widespread.
Canary will not be the only firm nailed for making illegal trades.
For fund investors, all of these scenarios are frightening. The question is whether they will ever become a terrifying reality.
Chuck Jaffe is a senior columnist at CBS Marketwatch. He can be reached at jaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.
