FINANCIAL POLICY FORUM

HAFFENREFFER: Alliance Capital will reportedly lower its mutual fund fees by as much as 20 percent. That is focusing attention now on the hidden costs that many investors pay to stay invested in the market. If Alliance does lower its fees then others may follow, and investors could end up saving big bucks.

But what about the even bigger question of investor losses due to improper mutual fund trading? Joining us from Washington, D.C. with his thoughts on mutual funds and your money, Randall Dodd, director of the Financial Policy Forum.

Welcome.

RANDALL DODD, DIRECTOR, FINANCIAL POLICY FORUM: Welcome, David. Hi.

HAFFENREFFER: When you heard this news that Alliance was voluntarily offering to lower their fees, your first impression was what?

DODD: It wasn't so voluntary. Spitzer negotiated and talked to them of reducing the fees as part of the penalty for the fraud they committed on their customers.

HAFFENREFFER: Is this necessarily to pay customers back on the part of larger customers, or this is something permanent?

DODD: I don't believe it is permanent. The $250 million fee that they're paying will also go to repay some of the losses that their customers have experienced over the past few years. And the fee reduction, as I understand it, will be temporary. And it will be about 20 percent over what they have been charging in the past.

HAFFENREFFER: Is this a proper type of settlement in your opinion?

DODD: I do. I think it's a pretty good idea. Spitzer has been somewhat thinking outside the box. It's a creative response to the situation. Alliance has had very high fees in an industry where fees are already, by most people's standards, too high. Theirs have been on average about 1.85 percent in an industry where fees are running around 1.5 percent. In that regards, it seems to be a kind of creative response.

HAFFENREFFER: This is an industry that, for the most part, does a pretty good job about detailing the fees that it charges its customers -- for the most part. Yet, you would be hard pressed to find a mutual fund customer today that knows exactly what they're paying in fees to mutual funds. Tell me about the transparency you see on that side of the business and how this may or may not affect customers in the future.

DODD: David, I think in many regards the mutual fund industry is lacking in transparency regarding fees. One proposal also on the table that the SEC, as well as Spitzer, as well as the mutual fund industry is talking about, are these bundled or soft dollar commissions.

What they do is they move a lot of their expenses out of the managing corporation and into each customer's account by paying the brokerage firm to buy and sell the securities for the mutual fund a higher than market commission on those securities trades.

And what that does is reduce transparency because people have a hard time figuring out how much they're really paying for research, for product placement by the brokerage, and other so-called, you know, supermarkets of mutual funds. And that has actually reduced transparency and made it hard for customers to, if you will, compete these overcharges out of the industry.

HAFFENREFFER: Most of the settlements that we heard about coming out of Wall Street in the past few years have led critics to say this is simply a slap on the wrist and will not necessarily prevent future types of fraud from taking place.

What are your thoughts as you look at the mutual fund industry at this point? Are any of the settlements you heard to date enough to keep people from being greedy?

DODD: Well, I think this is -- $250 million for one firm, I think that's a pretty substantial penalty. I think this reduction in fees will be an ongoing reminder to them that what they have done is very profoundly wrong.

I think also what we need is a legislative remedy to this. Clearly, we've been for decades now talking about deregulation and about impugning the quality of the government. And now we realized we made the wrong mistake and the government hasn't been allowed to keep up with the needs of these financial markets.

There are a couple legislative proposals that will be introduced in the coming Congress, and hopefully they will address not only these late trading and market timing problems but also address the rather high fee and management fee and brokerage fee, and other nontransparent costs to mutual fund customers.

I know that they're aware of them and I think we just have to really keep some pressure on them in hopes that that will be incorporated into new legislation.

HAFFENREFFER: Thank you, Randall.

· San Diego Union-Tribune

December 7, 2003

Tricks of the trade: The SEC is cracking down on two mutual fund scams, but some fear the reforms will be ineffective

By Craig D. Rose
UNION-TRIBUNE STAFF WRITER

Like a night guard awakened from a sound snooze, the Securities and Exchange Commission took its first shot last week at ending one of the scams that has quietly stolen money from the vast majority of mutual fund investors for years.

But this first action may be a shot in the dark, as some fear it will be unfair and ineffective. And that's the optimistic scenario.

While many in the investment industry have been quick to assert that typical investor losses from the unfolding mutual fund scams amount to only small change, investigations continue and the scope of the damage cannot yet be determined.

Just last week, for example, New York State Attorney General Eliot Spitzer filed a complaint against Invesco Funds for allegedly allowing rapid-fire trading, called market timing, by large investors in a fund it pitched through Young Americans Bank, which caters to customers under 22, as a place to invest for the long haul.

Those large, market-timing investors are hedge funds, unregulated investment vehicles for wealthy individuals and institutions seeking a high return through complex transactions.

In the Invesco case, the hedge funds' high trading volume added large transaction costs to the fund – costs shared by all shareholders. But the profits skimmed by flipping the shares in quick sales went only to the hedge funds.

Even worse, funds allowing market timing are often forced to sell shares at disadvantageous times. Managers may also find a need for more cash on hand than they would otherwise need.

The SEC action last week sought to slam the door on the simplest of the mutual fund scams, namely late trading. This practice allows some investors to place mutual fund trade orders after the 4 p.m. EST time deadline – when investors have had the chance to take in late-breaking news – and still get the 4 p.m. closing price.

Late trading is illegal and apparently widespread. Professor John Coffee Jr. of Columbia University, who specializes in the study of white-collar crime, said an SEC survey found that 25 percent of brokers allowed the practice.

SEC enforcement? Nil, according to a commission spokesman who said staff could not recall a single late-trading enforcement action.

New York's Spitzer, who has played the lead role in busting the scams, likened late trading to betting on a horse race after it's been run.

The SEC-proposed change would cut off trading at 4 p.m. While the so-called hard and fast rule is easiest to enforce, some say it will disadvantage smaller investors whose orders may take time to process.

An investor in San Diego with funds in a 401(k) plan, for example, might find that a trade he or she placed at noon PST time might not be completed until the next day because of processing delays. At the same time, an individual investing directly in a mutual fund might be able to get the same transaction processed the same day.

Groups including the American Benefits Council instead proposed using fool-proof electronic stamps on trade orders, which would provide auditable proof that trades were placed before the 4 p.m. market close, although they might be processed after the deadline.

The SEC also voted last week to require funds to have a compliance officer report to the board of directors and improve disclosure requirements.

Tens of millions of investors have a stake in the ability of the SEC to halt abuses. Although ownership fell slightly last year, 53 million households – about 48 percent of all homes in the United States – had mutual fund investments during 2002. More than half of those investments were retirement savings.

Randall Dodd, director of the Financial Policy Forum in Washington, D.C., noted that middle-class investors typically have about $80,000 invested in mutuals. At that level, even scams of a small percentage quickly compound into big bucks.

Using academic studies of losses from the two key mutual fund scams, Dodd said he believes that the average middle-class investor may have lost more than $3,500 over the past five years.

The calculation factors in what Dodd and others call mutual fund expense or commission overcharges, a whole other area of abuse, according to fund critics.

These charges take the form of management companies charging mutual fund shareholders more for advisory services, failing to provide discounts that funds claim to provide and padding expenses in other ways, Spitzer said.

In congressional testimony last month, the New York attorney general said a fund shareholder with $100,000 could have lost $6,000 over the past decade because of excess fees.

Spitzer said there's a connection between fees that are too high and the recently exposed scams. In exchange for their special privileges, he noted, hedge funds often agree to park money in other mutual fund investments, allowing managers to collect fees on those investments.

The attorney general further noted that although mutual fund investment grew 60-fold between 1980 and 2000, the industry's fees increased 90-fold. There have been no economies of scale, he said.

"The fees paid by mutual fund investors seem to defy the laws of economics," Spitzer said.

But investors have been largely oblivious to these fees, said Max Rottersman, president of fundexpenses.com, which tracks the cost of mutual investments.

"In California, people complained about the hundreds of dollars they paid for auto registration fees and ignored the hundreds of dollars they paid in mutual fund fees," Rottersman said.

University of San Diego law professor Frank Partnoy noted that the SEC was repeatedly warned about the scams that skimmed profits from mutual funds but did nothing. He believes that rule changes and high profile prosecutions may fail to eliminate the problems unless key incentives for scamming are eliminated.

"The authorities are not going to be able to round up everybody," said Partnoy, author of "Infectious Greed: Deceit and Risk Corrupted Financial Markets."

The key incentive, he said, is the failure of mutual funds to update their share prices continuously during the day. By setting prices just once daily, he said, fund prices are often stale in market terms and allow hedge funds to make money on the difference between the outdated price and the price that they can predict that shares will soon reach.

Add the damage from these arbitraging schemes to what Partnoy also said are excessive fees and he concludes, "Investing in mutual funds is a mistake for most investors."

Investors with a computer and Internet access can create balanced portfolios of perhaps two dozen stocks and beat the performance of most mutual funds, Partnoy said.

To be sure, that remains a minority view among investment experts. Nearly all experts, though, believe investors should be much more active in shopping for investments.

Mercer Bullard, a University of Mississippi law professor and founder of Fund Democracy, a mutual fund investor advocate, said activism should start with a careful reading of the fund's prospectus.

"If reading it gives you a headache, it's been written to discourage understanding," Bullard said. In that case, he said, move on to another fund.

Bullard and other investment advisers recommend that investors seek funds with below average expense fees. Most suggest paying no more than 50 basis points – equivalent to 0.5 percent – for passively managed funds, or funds that seek to mimic established indexes.

For specialty funds, investors should be wary of paying more than 1 percent for expenses, unless there are compelling reasons to do so.

"It is very difficult to overcome high fees," said Dale Stephens of Grasswood Partners, a Malibu consulting firm for wealthy individuals and pension funds. "You're going to have a hard time making up for that fee in terms of performance."

But he and others say properly managed and reasonably priced mutual funds are still a good deal for most investors.

"The majority of people cannot beat a mutual fund," said Charles Foster, a principal of Blankinship & Foster, a financial planning firm in Del Mar.

"It takes more than a little bit of study. And it takes gumption to buy when others are selling and to sell when others are buying."

Foster said he prefer mutuals even for relatively affluent investors, including those with more than $500,000 to invest.

"I'd rather have somebody with gray hair – or no hair – who has been at it for 30 or 40 years and who has the interest of investors at heart but does not overcharge for it," he said.

One point on which a sampling of investment advisers agreed was that investors should penalize those funds found to have allowed scamming by withdrawing their investments.

"Do not support a fund that is (allowing) market timing or late trading," said Neil Hokanson of Hokanson Capital Management, a Solana Beach investment adviser to pensions, nonprofits and wealthy individuals. "Pull money out of any fund that has violated the rules."

The SEC has yet to deal with the problem of market timing, which most experts believe has been more costly to average investors than late trading.

Market timing involves large investors who perceive discrepancies between how a fund prices its shares and its actual market value. This often arises in international funds, where a 4 p.m. closing price might be based upon the share prices in markets that closed more than 12 hours earlier.

Events since the close of the Asian market might strongly suggest that the price of the shares will rise sharply, so the large investors buy shares at the stale daily price of the U.S. mutual fund set at 4 p.m. and sell them the next day for tidy profit.

Funds bar most investors from this strategy by limiting the number of trades. But Spitzer is finding a growing number of funds that made special arrangements with larger investors allowing unlimited trading.

The SEC is considering slapping a redemption fee on short-term trades of perhaps 2 percent, reducing the profit incentive for market timers.

· The Street.com

The CFTC, Reluctant Regulator

11/26/2003

By Will Swarts

Whatever the Commodity Futures Trading Commission finds out about disputed asset pricing at the Clinton Group of hedge funds, the most surprising thing about the investigation is that it happened at all.

The federal agency that was once poised to become the most active regulator of the diffuse and opaque hedge fund industry spent the last three years backing away from its oversight role, to the point where some former CFTC officials worry that derivatives trading, a critical sector of U.S. financial markets, is dangerously unsupervised.

Under chairman James Newsome, a former lobbyist for the Mississippi cattle industry, the CFTC has reduced the criteria that once forced many hedge funds to submit annual reports as registered commodity pool operators and commodity trading advisers. In August, the agency passed a set of rules relaxing reporting requirements for hedge funds, many of which were overseen by the agency because they trade futures contracts.

The nearest thing the hedge fund industry has to a lobbying group is the Managed Futures Association. Since 2000, the MFA has stepped up its lobbying efforts with regulators, asking the Securities and Exchange Commission to let hedge funds advertise and pressing for minimal disclosure and registration requirements for fund managers.

While the Clinton Group is not a member of the Managed Funds Association, founder George Hall was a featured speaker at an MFA conference in June. Richard Clarida, Clinton's chief economic strategist, is scheduled to address another MFA conference in February.

Clinton's problems came to light in October, when senior trader Anthony Barkan resigned and issued a public statement about his concerns over possible mispricing in asset-backed securities portfolios in the firm's $4 billion hedge fund business. The firm quickly hired PricewaterhouseCoopers to check its valuations, but with hedge funds under the microscope, Clinton was soon visited by both the SEC and CFTC.

It was an unusual move for the latter.

"This is a very strange time for the CFTC to be investigating anybody," says one person who knows the agency well. The agency, this person says, has been stepping away from its regulatory duties since 2000 and gets involved in big investigations only when it can't avoid them.

"The CFTC took a deregulatory course, even though the SEC was moving in the other direction. They probably gave up regulatory jurisdiction over half the funds they regulated."

A CFTC spokesman says the agency doesn't comment on whether it is investigating particular firms, but says it is "very active with enforcement and investor protection." The agency's Web site lists 109 enforcement actions taken this year, many against foreign currency traders and energy derivatives traders.

But hedge funds are less of a priority. While the SEC now appears to be leaning in the direction of increased regulation for hedge funds, the MFA has succeeded in easing CFTC oversight. Part of the reason is the extensive contacts between the MFA and the agency it lobbies. MFA president Jack Gaine has a history of working well with Newsome, and last year the CFTC hired former MFA general counsel Patrick McCarty as its own general counsel.

While he lauds the deregulatory direction of the CFTC over the last several years, Gaine points out that the agency's antifraud provisions remain unchanged, and that funds could face criminal and civil penalties for misrepresenting or misvaluing their assets or performance.

Gaine has high praise for Newsome. "I share his views, particularly on market development," Gaine says. "I think he's the best, or one of the best, chairmen they've had over there."

"In this situation, you basically have the CFTC very much influenced by a lot of the industry groups it represents," says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the CFTC.

"Chairman Newsome is as deregulatory as any chairman the CFTC has had," says one agency veteran. "Once McCarty was brought in as general counsel, well, it certainly sent a signal."

The CFTC also delegates much of its investigative work to the National Futures Association, a self-regulatory organization that handles initial complaints and concerns about futures traders, similar to the way the NASD sometimes works in conjunction with the SEC.

But the CFTC does spend money and put resources into its own investigations; it sent $22.8 million of its tiny $82.8 million fiscal 2003 budget to its enforcement division, which is well regarded, though much smaller than the SEC's operation.

Randall Dodd, a former CFTC economist who now runs the Derivatives Study Center, a Washington think tank, says the agency has long been underfunded and understaffed, long before its recent deregulatory bent.

"You can't send David in against Goliath every day and expect him to win," he says. "The derivatives industry has grown so much faster than banking or equities or insurance, and regulation has not kept pace."

Dodd and Greenberger both say the agency's value was most apparent in 1998, when the CFTC was the only federal body that had any information on Long Term Capital Management, a heavily leveraged hedge fund that was on the verge of blowing up while holding derivatives with a notional value of $1.25 trillion.

After the Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New York convened to organize major investment banks in a hasty and expensive buyout of the bankrupt fund, the CFTC was the agency that called out for regulation of over-the-counter derivatives activity, says Greenberger.

"They recommended at the time that there be a rigorous reporting of hedge fund activities to the federal government, but the question about how it would be done was left open," he says. "But after [then chairman] Brooksley Born retired in 1999, each new chair became more devoted to moving from regulation to deregulation."

At the same time, he says, the Securities and Exchange Commission was starting to look more seriously at regulating hedge funds.

"Even Harvey Pitt saw that hedge funds were having an impact on the economy," Greenberger says. "Now the SEC is in the driver's seat, but it doesn't have the most direct regulatory tools that the CFTC had. And they've given up every meaningful regulatory peg they had."

Greenberger says the agency's enforcement actions now are directed at small-time operators, "and there are a lot of them and they can be very bad," but that it won't go after pillars of the futures industry.

"Look at the MFA -- they can't say enough good things about how good a regulatory agency the CFTC is, and that is because it is basically a toothless regulator. Anything they're doing with Clinton, they've basically been dragged into."

· Washington Post

November 7, 2003

Fund Scandal in New Territory

Definition of 'Insider Trading' Broadens

By Brooke A. Masters

Washington Post Staff Writer

Friday, November 7, 2003; Page E01

NEW YORK, Nov. 6 -- The exploding mutual fund scandal makes some regulators

and prosecutors wonder if they've uncovered a new kind of insider trading.

There is growing evidence that some fund company executives who had access

to inside information made short-term personal trades that may have hurt

their investors, and nearly a third of large fund families have admitted to

the Securities and Exchange Commission that they shared private portfolio

information with hedge funds, which are largely unregulated investment

pools for the wealthy.

"The fundamentally unethical nature of this conduct is obvious," said

Massachusetts Secretary of the Commonwealth William F. Galvin, who brought

a complaint alleging that two Putnam Investments portfolio managers

improperly made short-term trades in their own funds. "Clearly the fund

managers [who were] trading their own funds had knowledge that is not

shared with other investors . . . and they were making huge amounts of

money on this."

New York state Attorney General Eliot L. Spitzer, who on Sept. 3 became the

first to move against mutual fund abuses, and federal authorities said they

too are looking at whether any of the alleged conduct merits bringing an

insider-trading case.

"The issue of fund managers sharing portfolio information is . . . the

equivalent of receiving a tip from an insider about securities," said SEC

enforcement director Stephen M. Cutler. "We would consider the full array

of enforcement tools, including, where warranted, insider trading."

SEC Chairman William H. Donaldson, in a speech Thursday, said the scandals

"involving . . . insider trading at mutual funds have revealed wrongdoing

in the part of the securities industry where individual investors are most

exposed and must be protected. The wrongdoing must stop; past and present

malefactors must be brought to account through both civil and criminal

sanctions."

The SEC brings only civil insider-trading cases, which can lead to large

fines, but the agency also works with prosecutors to develop criminal cases

for the most serious offenses. In the case of the mutual fund

investigation, federal prosecutors in both Boston and Manhattan are deeply

involved.

No one has been charged with insider trading in the mutual fund scandal,

but the hedge funds and managers who have been cited in the investigations

used what authorities say may be insider information to engage in

"market-timing," making short-term investments that try to exploit the fact

that mutual fund prices, which change only once a day, can lag behind the

value of their holdings. While the strategy is legal, most funds say they

try to prevent it because market-timing increases fund costs and allows

short-term investors to make profits that cut into returns for longer-term

investors.

Legal experts cautioned that building an insider-trading case could be

difficult.

Classic insider trading involves a trader who has improperly gotten or been

given important nonpublic information about a particular stock and profited

from that information.

In the fund scandal, the timers had no special information about what was

going on with the underlying stocks owned by the mutual funds. But they

allegedly knew exactly what a particular fund was holding and therefore

might have been in a better position to judge which fund prices were out of

date.

For instance, if a fund was heavily invested in a particular European

computer company, its share price, which is set when markets close in New

York at 4 p.m., would have reflected what happened to that stock before the

close of European markets at noon the same day. If, between the close of

the European markets and the setting of the fund price, there was a

development that was likely to cause the computer company's stock price to

go higher the next day, the market timer would buy shares in the fund

anticipating a quick profit.

Regulators and investigators agree that the big challenge would be to show

that the insiders who traded had particular nonpublic information about the

funds that made their market-timing trades more successful.

For example, they are trying to determine if those who were market-timing

shares in a mutual fund sat on the fund's valuation committee and therefore

had direct, nonpublic information about how funds were going to change in

value on any given day, one regulatory source said. They're also looking at

situations where the timers -- but not other people -- knew that a fund had

a large position in a particular stock whose price was about to move

significantly, a second source said.

If such abuses are found, the first source said, "it's a new species of

insider trading."

"It's really a law professor's dream and a prosecutor's nightmare," said

University of Mississippi law professor Mercer Bullard. An alleged

perpetrator "can argue, 'I was buying on the same public information as

everyone else,' " Bullard said.

The example of Richard S. Strong, who resigned this week as chairman of the

Strong funds during the furor about his personal trading, may be crucial.

Spitzer has said he intends to bring an action against Strong for making

short-term trades in specific Strong funds while he chaired the board of

directors, which is supposed to look out for the funds' investors.

Investigators say that the company made an effort to stop timing in some of

its funds but that Richard Strong made a point of trading other areas.

"Strong is probably the poster boy for market-timing abuse, and he would be

a good candidate for criminal action," said Columbia University law

professor John C. Coffee.

But Strong's lawyer, Stanley S. Arkin, denied that his client ever misused

nonpublic information about the funds he oversaw. "It is incorrect as a

matter of fact and law to suggest that anything my client did could ever

amount to insider trading. That's just dead wrong," Arkin said.

Building a case against fund managers may be complicated by the fact that

many fund companies encourage their executives to invest in their funds

rather than trading stocks in their personal accounts. That rule was in

turn a reaction to earlier problems. In the late 1990s, the SEC discovered

situations where some portfolio managers were "front running" their own

funds by buying or selling particular stocks that the fund was going to buy

or sell.

Lawyers for the former Putnam portfolio managers who have been charged with

timing their own funds either declined to comment or did not return phone

calls.

The SEC and Spitzer's staff are also looking at whether mutual fund

executives violated insider-trading laws by sharing portfolio information

with hedge funds.

In Spitzer's settled civil complaint against Canary Capital Management LLP,

he alleged that several fund companies, including Strong and Bank of

America, shared information about their holdings with the New Jersey hedge

fund. That enabled Canary's manager, Edward J. Stern, to not only make

money in a rising market by timing but also to profit in a falling market.

Stern did that by buying financial instruments known as derivatives that

gained value when the price of stocks in the funds went down.

As a result, Stern, unlike less informed investors, was in a position to

make money no matter what happened. "People who can only buy the fund, can

only profit on a good day. But if you have a derivative, you can profit

either way," said Randall Dodd, director of the Financial Policy Forum.

"That's identical to insider trading because [the hedge fund] had knowledge

of the composition of the funds that others didn't."

Stern's lawyer, Gary Naftalis, did not return a message left with his

office. Outside lawyers said that some funds may have protected themselves

against insider-trading allegations by saying in their prospectuses that

they occasionally shared portfolio information with outsiders.

"You can't have insider trading unless you have a breach of a fiduciary

duty to keep quiet," said New York Law School professor Jeffrey J. Haas.

Given the murkiness of the law, the SEC, state enforcers and federal

prosecutors are looking for alternate punishments for conduct they find

egregious, officials and other sources said.

"We are looking at a whole range of criminal theories, larceny . . .

Derivatives Study Center

1660 L Street, NW, Suite 1200

· CNN fn

· San Diego Union-Tribune

· The Street.com

· Washington Post