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Investors fear worst with fund inquiries

An investigation by the SEC has led some to reconsider mutual funds.
Monday, December 8, 2003 | 12:00 a.m. CST; updated 5:57 p.m. CDT, Sunday, July 20, 2008

Lately, Dean Gentry has spent a lot of time worrying about the portion of his retirement nest egg that is invested in mutual funds. The more he thinks about it, the angrier he gets.

“I’ve got as much of a stomach as the next guy for stock market losses,” said Gentry, a 67-year-old Columbia resident and retired manufacturing executive. “But I didn’t sign up for fraud.

In September, New York Attorney General Eliot Spitzer launched a massive investigation into the mutual fund industry, alleging that some financial institutions allowed a hedge fund, Canary Capital, to engage in questionable trading practices. So far, Spitzer has implicated numerous institutions, including Security Trust Co., a Phoenix-based financial firm that manages $13 billion in assets for more than 2,300 trust and pension funds. A handful of Security Trust executives face criminal and civil charges, and the company has agreed to cease operations by March 31.

Gentry, who splits his days between Columbia and South Florida, is not sure yet what the allegations will mean for his investments, but he’s keeping an eye on Spitzer’s investigation.

“I’m going to wait it out until we get a better idea of just how widespread this thing is,” he said. “If I don’t like what I’m hearing, I might get out of mutual funds altogether.”

Margaret Palmer has already phased out the nearly 40 percent of her portfolio that was in mutual funds. A former financial adviser, Palmer said she’ll put her money elsewhere until reforms are instituted.

“I’m staying away,” Palmer said. “Right now, mutual funds are risky business.”

Mutual funds are geared toward small investors, like Gentry and Palmer, who want their portfolios to reflect a diversity of assets. The funds are managed by companies that invest the pooled funds of their customers for a fee.

Nearly half of all American households are invested in mutual funds, according to the Investment Company Institute, an industry trade group. Matthew James, of the Society of Financial Service Professionals, pegs the number of mutual fund investors a bit lower.

However, he said, “most people couldn’t tell you” where their money is invested.

“If you look at Columbia like a microcosm of the United States, then probably one in three Columbians own mutual funds,” James said. “That is a significant number of people who have a stake in this matter.”

Janet Pierce, a former teacher at New Haven and Rock Bridge elementary schools, invests in mutual funds through a 529 plan, a state-sponsored investment program designed to help families save for college. Along with 401(k) plans and IRAs — individual retirement accounts — 529 plans are some of the most popular vehicles for mutual fund investors.

“We started putting away money for college early,” Pierce said. “And I know mutual funds are a large part of our savings.”

Unlike stocks, whose prices fluctuate throughout the day, mutual fund shares are priced once a day. The Securities and Exchange Commission’s forward pricing rule mandates that orders placed after 4 p.m. receive the following day’s prices. So, normally if investors purchase a share of a fund at 4:30 p.m., the price they pay won’t be determined until the following day at 4 p.m.

Like mutual funds, hedge funds are a collection of securities, but they are geared toward a wealthier and, presumably, a more astute class of investors. Hedge funds usually require a minimum investment of $250,000. They are more loosely regulated than mutual funds, and hedge fund managers, whose compensation is directly tied to the fund’s return on investment, employ much more aggressive trading strategies.

Spitzer said some mutual fund companies have allowed hedge fund managers to buy shares after 4 p.m. at the current day’s prices, an illegal practice known as “late trading.” Late trading allows the hedge fund to take advantage of an after-hours earnings announcement or other event that could boost a stock’s price and, therefore, the value of the mutual funds that own the stock.

Spitzer has publicly likened the strategy to betting on a horse race after the results are known. David Friedman, an analyst with A.G. Edwards & Sons Inc., uses a similar analogy.

“It’s like buying a winning lottery ticket after the drawing has taken place,” Friedman said. “The hedge fund is the person buying the ticket, and the mutual fund companies are the clerk behind the counter making the illegal sale.

“And of course, you’re going to have to slip the clerk $20 so that he’ll sell you the late ticket.”

That theoretical $20 is known as a “sticky asset” — a multimillion-dollar investment by the hedge fund that acts as an incentive for the mutual fund to allow the hedge fund manager to engage in late trading, Spitzer said.

Spitzer said hedge funds are also using “market timing” to gain an advantage that smaller investors do not enjoy. Market timing, or “time zone arbitrage,” is a strategy that allows a hedge fund manager to take advantage of price differences between U.S. and international markets.

Banking on the theory that international markets tend to follow Wall Street, a hedge fund manager can react to a surge in U.S. markets by purchasing shares in mutual funds that include international stocks. If the international markets rally, there is a gain in the value of the mutual fund’s international shares, which can then be sold for a quick and easy profit by the hedge fund manager.

Market timing, which is considered unethical but not a violation of SEC regulations, dilutes the value of assets held by the mutual fund’s other shareholders. Indeed, the hedge fund’s profit often consists of the other shareholders’ losses.

“It’s not illegal, but it might as well be,” said Susan Holmes, a spokeswoman for the Investment Company Institute. “It’s one of the industry’s unwritten rules. They’re just not supposed to do it.”

Market timing and late trading also hurt smaller investors by adding to the mutual fund’s administrative costs, which are passed on to shareholders in the form of fees.

“These scams are a breach of the fiduciary duty to act in the shareholders’ best interest,” said Jonathan Davis, an investment representative with Edward Jones Investments. “A sound mutual fund investment strategy should focus on the long term.”

Davis says he hasn’t received any complaints from his clients, many of whom he says are heavily invested in mutual funds. But Edward Jones, along with a host of other financial firms, has proposed some industry reforms that include more disclosure of fund commissions and fees, as well as hefty fines for legal but unethical practices such as market timing.

Meanwhile, most experts don’t expect Spitzer’s investigation to trigger a wholesale bailout of mutual funds by investors. However, James said that in the wake of other highly publicized cases of financial impropriety, investors will likely be more careful when they pick a mutual fund.

“You’ve got to look at the positive,” he said. “People look at financial statements a lot more carefully than they did before Enron. Hopefully this, like that, will educate people and make them more carefully scrutinize mutual funds and the companies behind them.”


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