Mutual funds dip into cookie jar

By DAVID MOON, Moon Capital Management
September 14, 2003

Maybe we're scandal weary. If you see enough litter on the highway, eventually it becomes part of the landscape.

Someone dumped a bunch more garbage on the street this week - Wall Street - and hardly anyone noticed. And it was some pretty filthy garbage.

New York Attorney General Elliot Spitzer made headlines again when his office forced a hedge fund to pay a $40 million fine for inappropriate trading in several mutual funds. No mutual fund companies were charged with wrongdoing.

Just wait. The smelly stuff has not yet hit the fan.

These fund companies entered into agreements with a hedge fund to allow trades that were clearly detrimental to the other shareholders. The mutual fund companies involved are big names. Janus, Strong, Bank of America and Bank One. The hedge fund was allowed to trade mutual fund shares long after the 4:00 PM market close, allowing the hedge fund to take advantage of after-market news about stocks in the funds' portfolios. These mutual funds also allowed the hedge fund manager to do daily market timing trades, in explicit contradiction to the funds prospectuses - the agreement between the mutual funds and shareholders. Every dollar of profit the hedge fund made from these trading strategies came directly from the pockets of the other mutual fund shareholders.

In exchange for letting the hedge fund take money from the pockets of the unsuspecting shareholders, the hedge fund agreed to invest tens of millions of dollars in other funds managed by Janus, Strong, Bank of America and Bank One.

The SEC is now questioning more than 80 fund companies about such practices.

Although the mutual fund companies haven't been charged with any wrongdoing, they appear concerned about the issue. Janus and Bank of America have already promised to make restitution to their shareholders, once they figure out how to determine how much their shareholders lost.

"Whoops. You caught us. We won't do it again. Here is some money to make it better."

According to Elliot Spitzer, the fund companies' actions were not the result of a few low level, rogue employees. The executives of these companies knew of the arrangements. In some cases, the top executives approved of the arrangements, over the objection of lower level employees.

With a couple of exceptions in the 1960s, the mutual fund industry has managed to avoid any significant scandal. Like all of the financial industry, mutual funds are based on trust. But unlike much of the financial industry, a mutual fund shareholder has to trust someone he never sees or knows. There are a lot of risks you must evaluate before you stick that check in the mail to your mutual fund company or make a change in your 401(k) plan. You have to decide to put money into the market. Then you have to decide what segment of the market you want to buy. Small cap? Large cap growth? International? How about diversification?

And now, it seems, you have to try and determine if the fund company is going to try and cheat you.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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