What is this scandal about? The allegation is that the US mutual fund industry – the equivalent of the UK unit trust industry – has been creaming off huge profits at the expense of the long-term retail investors who give mutual funds their savings. Eliot Spitzer, the New York State attorney-general, who last year forced Wall Street banks to pay up more than $400m in settlement of charges of promoting dotcom stocks they knew to be worthless, has turned his attention to the $7trn mutual fund industry after becoming concerned about ‘market timing’. So far, more than a dozen companies have been implicated and 50 executives have lost their jobs. Now the scandal has spread to the UK with the news that Britain’s Amvescap is under investigation for the activities of its US subsidiary, Invesco Funds Group.
What is market timing?
It is the rapid trading of mutual fund or unit trust shares to exploit short-term anomalies in the pricing of funds. Most funds are valued just once a day because there are too many underlying shares involved to do so more frequently. In the US, mutual funds are usually priced at 4pm, when the New York market closes. In the UK, unit trusts are valued at 12 noon. This once-a-day pricing means that the prices may be based on out-of-date information. For example, a market timer could cash in on the fact that a US fund manager has used Japanese share prices that are 15 hours out of date. Another practice under investigation by Spitzer and the Securities & Exchange Commission (SEC) is late trading. This involves buying or selling shares after the price has been set – which is like betting on a race after the horses are past the finishing post.
What is wrong with it?
Market timing is legal, but considered unethical: it can damage the interests of long-term investors in the fund because it forces funds to hold higher levels of cash to meet redemptions and sometimes to sell at inconvenient times. In one of a number of e-mails to have come to light as a result of Spitzer’s investigation into Invesco Funds Group, part of Amvescap, Tim Miller, the chief investment officer at the fund manager, accused market timers of “day trading in our funds and costing legitimate shareholders significant performance”. Market timers had bought $180m worth of its Dynamics Fund and sold the next day. “I had to buy into a strong rally yesterday, and now I’m in negative cash this morning because of those bastards, and I have to sell into a weak market. This is NOT good business.”
Can private investors do this?
No. Most funds have rules preventing small investors trading in and out of their funds. The prospectus for the IFG Dynamics Fund, for example, states that investors are allowed four trades in and out of the fund in any 12-month period. But the fund management groups made special exemptions for market timers because they earn commissions on their trades. Indeed, Invesco is alleged to have kept these arrangements offered to its so-called ‘Special Situations’ clients secret from ordinary investors and even the independent boards of its funds.
How has Amvescap responded?
It is “vigorously” contesting the charges, arguing that it tried to identify and curb harmful market activities. It points to 400 cases where it has shut out market timers. The problem is that it can be hard for management groups to identify real market timers. Big customers moving in and out may be market timers, but they could also be fund supermarkets grouping together their client orders through brokers, for example. Moreover, market timer trades are often not large enough in relation to the size of the underlying funds to arouse the suspicion of fund managers.
Who else has been caught up in this scandal?
The latest to join the list is Boston-based Massachusetts Financial Services, the oldest US mutual fund company and the 11th largest with $175bn under management. Last month, Putnam reached a settlement with the SEC. It is expected to be fined and has fired its chief executive. Canary Capital Partners, a hedge fund, has paid $40m to settle allegations. Alliance Capital has set aside $190m to cover the cost of any redress to investors. And Morgan Stanley has paid $50m after admitting it took extra commission to promote certain funds.
What will the scandal cost the industry?
The industry is likely to be hit with huge fines and changes to its working practices. The SEC has cited a paper by Eric Zitzewitz of the Stanford Graduate Business School that claims market timing has cost fund investors $25bn since 1998. Jon Kirk, an analyst at Fox-Pitt Kelton, estimates that Amvescap, if found guilty, may have to pay out $300m. The total bill for the industry could be $4bn. The biggest problem for the implicated funds is the damage to their reputations. In November alone, Putnam lost $32bn, or 12% of its funds under management. Amvescap’s shares have slumped more than 30% since the scandal erupted.
Could it happen here?
Many UK fund managers admit they have been approached by market timing groups. In addition to the allegations against Amvescap, another London-listed fund manager, Old Mutual, has seen the two founders of its Pilgrim Baxter subsidiary charged with allowing favoured clients to make inappropriate trades. Moreover, there are a number of successful market timing funds based in London, including the secretive Pentagon Capital Management. Callum McCarthy, the chairman of the Financial Services Authority, is sufficiently concerned about market timing that he summoned chief executives of top fund groups to appear before him earlier this month.