Mutual fund cleanup: Washington's surprisingly slow-motion efforts at reform

International Economy, The, Wntr, 2004 by Roger M. Kubarych

America's financial markets--and the nation's reputation for market integrity--have been rocked by repeated scandals in recent years. But perhaps the most egregious scandal of all swirls around segments of the mutual funds industry. Mutual funds in the United States have exploded in size and significance in the past two decades. At mid-year 2003, total equity and bond funds held just over $4 trillion in assets. Twenty years ago they amounted to an insignificant $47 billion. In addition, money market funds totaled $2.1 trillion at mid-2003. Twenty years ago they did not exist at all.

Almost one hundred million Americans have a stake in mutual funds. Mutual funds are perhaps the single most important ingredient in the quiet revolution of the U.S. pension fund system, away from company-organized and company-managed defined benefit pension plans and toward a system of employee-directed defined contribution pension plans. Roughly half of all 401(k) accounts are invested in mutual funds and roughly half of all investments in equity mutual funds are 401(k) investments. So what happens in the mutual fund industry has enormous consequences for the long-term retirement savings of millions of Americans. That makes it a political, not just a financial market, issue.

Despite the scandals that plagued other parts of the U.S. financial system, mutual funds had been almost entirely spared the bad headlines and lawsuits--that is, until September 2003, when New York State Attorney General Eliot Spitzer revealed that a number of mutual funds were ignoring, or worse, facilitating, illegal or questionable trading by certain individuals and investment institutions, including hedge funds. Those activities directly diluted the financial positions of the small retail investors whom mutual funds are meant to serve. Since the initial revelations, the scandal has broadened to involve more funds and other varieties of questionable behavior.

In addition to the mutual funds themselves, the other major casualty of the scandal has been the reputation of the industry's primary regulator, the Securities and Exchange Commission. On September 3, 2003, SEC Chairman William H. Donaldson made a statement after the Spitzer action that, "The conduct alleged in the complaint is reprehensible and there is no place for it in our markets." But he went on to concede, "There is too much at stake for us to know as little as we do about these funds, in particular, and how they operate." It is rare for the head of a major regulatory body to make such an admission.

Once the scandal was out in the open, the SEC moved with dispatch--and in coordination with Spitzer and the Attorneys General of other states--to initiate civil and criminal proceedings. Indeed, the best descriptions of what wrongdoing was done and how are to be found in the court documents which are readily available on the SEC's website.

How can these abuses be prevented in the future? A modest beginning has been made. The SEC has taken some small steps to curb abuses but is meeting resistance on some of them. The U.S. House of Representatives overwhelmingly passed a bill submitted by Financial Services Committee Chairman Michael Oxley (R-OH), of Sarbanes-Oxley fame, with only two negative votes. However, as of mid-December the Senate had not come up with its own bill. Several mutual funds themselves have already responded, either by firing executives or traders or by establishing new roles. Others are lying low. But adding it up, the corrective efforts so far have been insufficient to repair the damage and construct a secure basis for protecting the small investor for whom mutual funds are designed. Much more can be done over and above what has been put forward by the House and by the SEC.

WHAT WAS THE WRONGDOING?

Most questionable activities stemmed from the particular convention that is followed in the pricing of U.S. mutual funds and transactions in them. That is, all the buy orders and sell orders for a mutual fund for an entire trading day are executed at the net asset value calculated at the normal close of business of the New York Stock Exchange, 4:00 p.m. Eastern time. It is illegal to buy or sell after 4:00 p.m. for settlement at the 4:00 p.m. price. That would allow the crooked trader the ability to make a sure profit at the expense of all other fund holders.

Other types of activities are legal but deplorable, such as rapid in and out trading to take advantage of pricing anomalies between the true value of the individual securities held in a mutual fund's portfolio and the formula used to compute net asset value. This practice has been confusingly referred to as "market timing" (the same term used to describe a totally unobjectionable, but difficult, portfolio strategy). A better term would be "stale price arbitrage." That is because the clever or corrupt trader is taking advantage of the fact that transactions will not be conducted at fair market value, but at prices that are outdated. Especially for funds that invest all or a good part of their assets in international securities, the prices used to compute the net asset value would have been set many hours before, for example at the close of the previous session's trading in Tokyo or Frankfurt