What
Went Wrong with Mutual Funds?
In the
midst of a seemingly endless flood of accusations against many of the nation’s
mutual fund companies, regulators are now scrambling to find solutions for
cleaning up the industry and protecting investor interests.
Here’s a look at what fund companies are being accused of and the measures
being taken to ensure future integrity.1
Loyalty Compromised
As with many recent Wall Street scandals, mutual fund companies have been caught
in a conflict of interest. Those accused of wrongdoing have allegedly catered to
large institutional investors at the expense of individual long-term
shareholders by allowing larger clients to engage in two improper trading
practices: market timing and late trading.
Both of these practices take advantage of the fact that mutual fund shares are
priced once a day, at 4:00 p.m. Eastern time. Although the underlying value of a
fund’s shares may change throughout the night in reaction to world events, the
price itself does not change until the next day. Market timing and late trading
enable investors to take advantage of the discrepancy between share price and
underlying share value.
Market timing isn’t illegal, but most fund companies say they discourage it
because it can dilute gains for long-term shareholders.
Here is an example of how it works. Assume U.S. stocks rally in afternoon
trading on a day when overseas markets have been flat or suffered losses. A
market timer purchases shares of a mutual fund that invests in overseas stocks,
banking on the hope that the fund’s value will rise during the night as
overseas markets react to U.S. gains. If the value does rise, the market timer
quickly sells his shares the following day and pockets the profit. The problem
with this strategy is that the money used to pay his short-term profit
diminishes the overall gain for all other shareholders.
Unlike market timing, late trading is illegal. Late trading takes place when an
institutional investor places orders to buy and sell shares during the day —
but doesn’t actually tell the mutual fund company which orders to process
until after the 4:00 p.m. price has been set. If world markets experience a
major sell-off during the night, the institutional investor cancels the
“buy” orders and processes the “sell” orders to lock in the preceding
day’s price.
Street Sweeping
Although trading regulations have yet to change, the Securities and Exchange
Commission has presented a number of ways to eliminate these improper practices
in the future. One potential regulation would require market timers to pay a 2%
penalty and fund companies to provide full disclosure of their policies relative
to short-term trades. Fund companies may also be required to appoint a chief
compliance officer who would be responsible for overseeing short-term trading
and disclosure issues.
Legislators on Capitol Hill are also suggesting reforms, including requiring
that two-thirds of mutual fund board members and the chairman of the board be
independent of the fund company. Some have also proposed that a fund’s
chairman of the board and chief compliance officer be required to certify
results — much like corporate executives are now required to sign off on
financial statements under the Sarbanes-Oxley Act. In addition, lawmakers want
to consider whether an independent oversight board is needed to regulate the
mutual fund industry.
Which if any of these regulations will become law may not be known until early
next year, but it seems clear that changes will be made to increase mutual fund
governance and create more transparent disclosure for investors. Staying abreast
of the debate over reforms may help you understand what you can expect from the
mutual fund industry in the years to come.
1) There are fees and expenses associated with investing in mutual funds,
including portfolio management fees and expenses and sales charges. Mutual funds
are sold by prospectus only. Be sure to read the prospectus carefully before
deciding whether to invest.
© 2003
Emerald Publications
