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SEC knew about dicey fund pricing

The Securities and Exchange Commission has known for nearly six years about the sloppy pricing of mutual fund shares, but the agency has initiated only a handful of low-profile enforcement actions. — By John W. Schoen
SEC Chairman William Donaldson at a Senate hearing this week, where he said his agency was examining the mutual fund and hedge fund industries.
SEC Chairman William Donaldson at a Senate hearing this week, where he said his agency was examining the mutual fund and hedge fund industries.
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The Securities and Exchange Commission has known for nearly six years about the sloppy pricing of mutual fund shares that one study estimates is costing individual investors as much as $5 billion a year, but the agency has initiated only a handful of low-profile enforcement actions, a review of SEC statements and documents by has found.

Following last week’s complaint against four fund companies by New York Attorney General Eliot Spitzer, the SEC announced that it would investigate mutual fund pricing practices which have been estimated to have cost tens of millions of long-term investors billions of dollars. Spitzer’s investigation found that at least four mutual fund companies — including Janus, Banc One, Strong and Bank of America’s NationsFunds — made secret deals with a hedge fund that allowed it to make rapid fire trades in fund shares at the expense of individual investors who hold the funds for the long haul.

As Spitzer unveiled his allegations in New York, SEC Chairman William H. Donaldson issued a statement saying that “the broad participation by individual investors in mutual funds requires that we do everything possible to understand, anticipate and address areas where there is the potential for abuse and fraud.”

But a review of public statements and letters from SEC officials shows that, though the commission first identified the problem nearly six years ago, it has taken only a handful of enforcement actions against smaller mutual funds for sloppy pricing practices — despite repeated warnings to the industry’s trade group, the Investment Company Institute, to clean up its act.

An SEC spokesman said during that period, actions were taken against at least “six to eight” of the roughly 8,300 U.S.-based mutual funds, but said a more thorough list was difficult to obtain because of the way the agency classifies enforcement actions. (Senior SEC officials were not available for comment.)

Researchers estimate the practice, in which professional traders take advantage of small discrepancies in fund share prices, costs individual investors upwards of $5 billion a year. For international funds, which are most vulnerable to short-term trading schemes, the cost to long-term holders can be as much as one percent of fund assets, or roughly what those fund investors are already paying in fees, according to an October, 2002 study by Stanford University economics professor Eric Zitzewitz.

SEC’s first warning

As far back as 1997, the SEC began warning the mutual fund industry that its pricing practices were leaving funds open to speculation by professional traders — at the expense of buy-and-hold individual shareholders. In a Dec. 4, 1997 speech to the ICI’s Securities Law Procedures Conference, Barry Barbash, the SEC’s director of investment management division, reminded the industry about pricing rules established in the 1960s and outlined the results of an SEC review of mutual funds that held shares traded in then-highly volatile Asian markets.

At the time, that volatility left wide gaps in mutual fund share prices from one day to the next — gaps that allowed savvy investors to swoop in and make big profits with quick trades. The SEC review, said Barbash, suggested that “fairly large numbers of investors attempted on Oct. 28 and 29th to take advantage of” these price gaps. Even redemption fees of as much as 1.5 percent — which quick-buck traders would have to pay — “did not deter this activity, which promised investors potential gains in double digits on those days,” Barbash told the industry.

“Taken as a whole, the results of our recent exams and disclosure reviews have convinced us that we need to undertake a broader and more comprehensive analysis of fund pricing issues,” he said in the 1997 speech.

The problem was clear-cut: If a mutual fund doesn’t properly factor the impact of a big move in overseas markets into its daily share price, those delays give speculators as much as half a day to take advantage of “stale” prices. Though not illegal, the practice allows a few professional traders to take advantage of price discrepancies at the expense of the majority of fund shareholders who are invested for the long haul.

Spitzer has likened the related, illegal practice of “late trading” — in which professional traders are allowed to trade fund shares after the 4 p.m. ET close — to “allowing betting on a horse race after the horses have crossed the finish line.”

On Thursday, Zitzewitz released additional analysis of his data estimating that illegal “late trading” is much less of a problem - amounting to losses to individual investors of about $400 million a year.

Second warning

But despite the continued toll on individual investors who held shares for the long-term, the practice apparently continued — even after the Asian markets calmed down. By 1999, the SEC formally warned the mutual fund industry, this time in a letter to the ICI’s chief counsel, Craig Tyle, urging the industry to apply greater scrutiny to its pricing practices, which continued to provide savvy traders with an opportunity to siphon money from long-term fund investors.

On Dec. 8, 1999, in a 3,500-word letter to the ICI, Douglas Scheidt, the chief counsel of the SEC’s Division of Investment Management, reminded the industry of its obligation to use so-called “fair value” pricing to curb speculation in its shares. The letter offered a detailed review of the applicable SEC rules already on the books and urged the industry to clean up its act.

“When pricing procedures are relatively vague, we believe (a mutual fund) board’s involvement must be greater and more immediate,” Scheidt told Tyle.

Third warning

But that reminder apparently wasn’t sufficient. In April, 2001, after additional academic studies detailed the continued speculation in fund shares by traders, Scheidt wrote a 5,000-word letter to the ICI’s Tyle — again reviewing the rules and urging the industry to take action to protect buy-and-hold individual investors.

“Fair value pricing can protect long-term fund investors from short-term investors who seek to take advantage of funds,” Scheidt advised the industry, including in his letter an example showing specifically how stale pricing hurt long-term investors.

By last year, the mutual fund industry’s pricing practices had drawn further scrutiny from the academic community.

The October, 2002 Stanford study by Zitzewitz, cited by Spitzer in his complaint, found that sloppy pricing practices continued to cost long-term investors nearly $5 billion a year.

In addition to his research, Zitzewitz says he consulted with mutual fund companies, advising those who were working to correct the problem of sloppy pricing. But he says relatively few of them were interested.

“There was a surprising lack of enthusiasm for fixing the problem from mutual fund companies,” he said.

As for the SEC’s reluctance to move more aggressively, Zitzewitz said that’s “another mystery,” but he speculates that industry pressure may have played a part.

”(The SEC is) under a fair amount of political pressure — a letter from a Congressman and white papers from an industry that gives quite a lot of money in terms of political contributions,” he said.

Industry pressure

Other former SEC staffers have said that in the late 1990s the agency was badly outgunned by the financial services industry, as SEC funding failed to keep up with the rapid growth of investing and mutual fund ownership.

From 1991 through 2001, the SEC’s annual budget rose from $189 million to $423 million, an average annual increase of about 8 percent. During that period, total mutual fund assets rose five-fold, while New York Stock Exchange volume rose nearly seven-fold and the number of corporate filings rose 60 percent.

“In defense of the SEC, much was attributable to the funding resources, which has only in the last several years have been addressed in Congress, and the enormity of growth in the market,” said Rep. Richard Baker, (R-La.)

Baker, the chairman of a House financial services subcommittee, has sponsored a bill calling for tighter regulation of the mutual fund industry.

Others suggest that the mutual fund industry’s opposition to further regulation was a factor in allowing professional traders to take advantage of sloppy share pricing practices. Indeed, the rapid growth of the industry in the 1990s and the widespread holding of mutual funds by American investors have given the industry a strong voice on Capitol Hill, according to Gary Gensler, a former Treasury undersecretary and co-author of “The Great Mutual Fund Trap.”

“The industry is a very powerful lobbying machine,” he said. “This is an industry that has customers in 55 million American households. That’s over 100,000 households per Congressional district. There’s a lot of stock brokers in every Congressional district who are feeding at this trough.”

But Spitzer’s recent allegations about trading abuses — and losses suffered by individual investors — may have given new momentum to regulatory reforms of the industry.

“People have been burned pretty badly,” said Roy Green, the legislative representative for housing and financial services at the AARP. “So it wouldn’t take much of a scandal for them to become concerned about the mutual fund industry.”

Even before the New York Attorney General’s office filed its complaint, Congress had begun asking why the SEC wasn’t doing more to regulate mutual funds. On March 26, 2003, Baker wrote to SEC chairman Donaldson with a long list of concerns about the mutual fund industry, including matters of corporate governance and the availability of information about the true cost of investing in a mutual fund.

“I am troubled that there may be insufficient transparency of mutual fund fees, costs, and operations,” Baker wrote. “I am also concerned about mutual fund governance and the performance of fund directors, fund distribution practices, and other matters.”

The result, the Mutual Funds Integrity and Fee Transparency Act of 2003, (H.R. 2420) eventually made its way out of Baker’s committee and is awaiting a vote by the full House. So far, there has been no action on the issue from the Senate.

Recent allegations by Spitzer’s office could spur more support for the measure. But Baker says the bill will now have to be revised — a process that will take more time.

“It will take us a while to work our way through this thicket,” he said.

Last week, the ICI issued a statement saying that “its members are deeply concerned over the allegations described” in Spitzer’s investigation. The group also announced that its president, Matthew Fink, will step down at the end of 2004, and that a committee has been formed to find a successor.

An ICI spokesman says the industry has supported past efforts to provide investors with more information and is “open to the idea” of further disclosures of information like fund transaction costs.

But adding more information to an already dense mutual fund prospectus may not be enough level the playing field for individual investors, said the AARP’s Green.

“Most Americans are so dependent on the advice they’re given by others,” he said. “If you’re looking at two very complicated fields — finance and law — it shouldn’t be surprising to find that most Americans find that it’s a challenge to find out what’s going on.”

Meanwhile, shareholder advocates say they expect mutual fund industry will likely continue to try to block regulations calling for fuller disclosure of its costs and practices.

“Why would any industry want to raise awareness of its costs when the risk is they will lose market share to bankers and brokers and hedge fund managers?” said Mercer Bullard, a securities law professor at the University of Mississippi Law School and former Assistant Chief Counsel in the SEC’s Division of Investment Management.