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

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

These market timing or stale price trades inflict harm on existing investors in a fund, who are normally small investors who simply buy and hold a fund for the long term. If the corrupt traders reap profits, those can only be at the expense of the passive investors in the fund. For many years, mutual funds themselves have recognized their capacity for ripping off the little guy, and they have tried, with more or less diligence, to discourage the practice. Many mutual fund prospectuses contain specific references to market timing, state that the fund's policy is to discourage the practice, and explain how it intends to implement that policy. Diligent enforcement was rare, unfortunately.

What takes the matter from sheer sloppiness to possible discouraging fraud is when the fund ignores its policies and actively facilitates market timing, often for a quid pro quo. Consider a February 2003 internal memo written by Timothy J. Miller, chief investment officer of Invesco Funds Group Inc., a company charged by the authorities for civil securities fraud: "These guys ... are day-trading our funds, and ... they are costing our legitimate shareholders significant performance. I had to buy into a strong early rally yesterday, and now I'm negative cash this morning because of these bastards and I have to sell into a weak market." The memo was cited in the SEC complaint, along with Invesco's own data showing that trading was costing ordinary mutual fund investors nearly one percent a year. Invesco's parent, Amvescap PLC, has denied any wrongdoing and will contest the charges.

It is too soon in the investigations to know how widespread the abuses have been, but every day it seems a new allegation is made public. Industry leaders have given diametrically opposed judgments--guesses, really--of how far the corruption goes. One respected CEO was quoted as saying it was just a "few rogue traders," but how would he have known? If he did know, did he tell the SEC or the cops about it? Others claim that "everybody did it," a frequent defense for everything from tax evasion to philandering.

Based on the genuine sense of outrage with which most people in the industry reacted to the news of the scandals, it is fair to conclude that the revelations came as a big surprise. The SEC testified to a U.S. Senate subcommittee in November on the results of a one-time survey they had done to gauge the extent of possible infractions. The results were damning. Twenty-five percent of funds knew of instances of late trading, while up to 50 percent knew of funds that facilitated market timing by favored customers. That is not just a "few rogue traders" and is too close to "systemic" for comfort.

THE INSUFFICIENT REGULATORY RESPONSE

The SEC certainly found out something was wrong by last spring, when a regional office was contacted by a whistleblower about questionable practices at a major fund. The office seems not to have investigated. The SEC held a Roundtable on issues related to corporate governance of mutual funds back in 1999 and the topics of late trading and market timing abuses didn't make it to the agenda. But in 1997, the chief of the division that enforces the rules and regulations covering investment companies (the formal name for mutual funds), called attention to potential abuses, including market timing. In any case, it does not seem that the SEC had a systematic program to uncover wrongdoing in the management of mutual funds. Now it is trying to get up to speed.