171. The 'after-hours' scandal
How was it that ordinary investors (and pension funds) gained about 3 % a
year between 1984 and 2002 while, during the same period, the average top
500 corporations gained 12 %? I had an intuitive sense that this might
have been going on in the '60s when I was a young man investing in what
the Americans call mutual funds and we call unit trusts. Somehow the fund
in which I invested, which had been growing at a cracking pace for the
previous few years, somehow slowed down. When the management's fee was
taken out of the rise, there wasn't a fat lot left. I began to feel quite
paranoic about this -- as though I was having some bad effect on anything
I invested in.
After a year or two of this I realised that some sort of scams were
involved and haven't invested since -- except in businesses which I
started myself -- but I've often thought since then how it was that
investment fund managers and pension fund trustees were able to perform
so lamentably without being found out. Or perhaps they were just
inefficient. But it couldn't have been that, surely! Even they could not
be so inefficient unless they were trying hard at it. Ove the
course of time, I put my fingers on two practices which I thought were
likely.
One is that a mutual fund corporation usually has many different funds.
In fact,during good times, it is starting new ones all the time, each
with a different equity flavour. They get them quoted for record purposes
but don't advertise them and largely leave them alone for a year or two.
In moderately good times, and especially in boom times, at least one of
those funds will do especially well over a period of two or three years.
It is then that the mutual fund selects the best, advertises it heavily
and receives large inputs of ordinary investors' money. Its performance
then drops down to the average.
Why this happened, as I thought, was that managers started to buy and
sell the shares in its newly promoted fund just as fast as was possible,
and thus having to pay commissions each time -- and thus picking up
backhanders from stock brokers every time they did so. I then discovered
that this was so and, in fact, it was so common that it had acquired a
sobriquet -- 'share churning'. Fund managers were turning over shares
every few months in companies such as oil corporations which should be
invested in for years, even decades, at a time. This is how Warren Buffet
invests his and his clients' money and, of course, it made him into a
billionaire and his clients into millionaires over the course of
time.
Well, that's about as far as I got in my arm's length examination of the
ways of the stock market, its brokers, and its allied pension funds, life
assurance businesses, mutual funds and the like -- the ultimate fallguy
being the ordinary investor. If there were more fiddles then, as an
outsider, I would be unable to discover them. But lately, with the huge
losses made by many pension funds and life assurance companies and
investigation by the New York state attorney, Elliot Spitzer, further
nasty creatures are coming out of the woodwork. Somewhat more leisurely,
the Financial Services Authority in England have been forced to take an
interest.
By coincidence, two well-informed writers have contributed trenchant
articles to the New York Times and the Financial Times on
the same days on further scams of which I had no knowledge and I follow
with them below for your edification if you are interested. The point
that must be made here is an obvious one but it needs to be stated again.
It is that until the scandals of the last 10-15 years (at least) are not
sorted out and made fully transparent, the ordinary investor and
pensioner has been so badly treated so far that he or she is never going
to invest again in worthwhile quantities and will continue to carry on
the present spending spree until catastrophe strikes. Instead of saving,
and seeing their savings grow in order to make for a comfortable
retirement, the average household pair now has debts above and beyond
their mortgage of approaching $10,000. Half of those who have paid for
their holidays in Benidorm by credit card have not even paid for the
previous year's holiday. And half of those haven't paid for the year
before that!
Although the ordinary investor and pensioner has been manipulated in
criminal fashion by a large part of the financial services market,
perhaps he or she is not quite so stupid. Perhaps he realises that the
catastrophe will be so great that, if he is in danger of losing his job
and not able to pay for his house and his debts, then the total national
catastrophe will be so great that the government will have to step in and
publish some sort of debt amnesty (as banks often have to do for their
biggest debtors) and/or start currency inflation in earnest so that jobs
and consumer spending can be re-stimulated and debts can be whittled down
quickly with the declining value of money over a few years.
Keith Hudson
<<<<
FUNDS AND GAMES
Paul Krugman
You're selling your house, and your real estate agent claims that he's
representing your interests. But he sells the property at less than fair
value to a friend, who resells it at a substantial profit, on which the
agent receives a kickback. You complain to the county attorney. But he
gets big campaign contributions from the agent, so he pays no
attention.
That, in essence, is the story of the growing mutual fund scandal. On any
given day, the losses to each individual investor were small which is why
the scandal took so long to become visible. But if you steal a little bit
of money every day from 95 million investors, the sums add up. Arthur
Levitt, the former Securities and Exchange Commission chairman, calls the
mutual fund story "the worst scandal we've seen in 50 years"
and no, he's not excluding Enron and WorldCom. Meanwhile, federal
regulators, having allowed the scandal to fester, are doing their best to
let the villains get off lightly.
Unlike the cheating real estate agent, mutual funds can't set prices
arbitrarily. Once a day, just after U.S. markets close, they must set the
prices of their shares based on the market prices of the stocks they own.
But this, it turns out, still leaves plenty of room for
cheating.
One method is the illegal practice of late trading managers let favored
clients buy shares after hours. The trick is that on some days,
late-breaking news clearly points to higher share prices tomorrow.
Someone who is allowed to buy on that news, at prices set earlier in the
day, is pretty much assured of a profit. This profit comes at the expense
of ordinary investors, who have in effect had part of their assets sold
off at bargain prices.
Another practice takes advantage of "stale prices" on foreign
stocks. Suppose that a mutual fund owns Japanese stocks. When it values
its own shares at 4 p.m., it uses the closing prices from Tokyo, 14 hours
earlier. Yet a lot may have happened since then. If the news is favorable
for Japanese stocks, a mutual fund that holds a lot of those stocks will
be underpriced, offering a quick profit opportunity for someone who buys
shares in the fund today and unloads those shares tomorrow. This isn't
illegal, but a mutual fund that cared about protecting its investors
would have rules against such rapid-fire deals. Indeed, many funds do
have such rules but they have been enforced only for the little
people.
In some cases fund managers traded for their own personal gain. In other
cases hedge funds, which represent small numbers of wealthy investors,
were allowed to enrich themselves. In return, it seems, they found ways
to reward the managers. You make us rich, we'll make you rich, and the
middle-class investors who trusted us with their money will never know
what happened.
And there's probably more. During last year's corporate scandals, each
major company that came under the spotlight turned out to have engaged in
some original scams. By analogy, it's a good guess that the mutual fund
industry was cheating its clients in other ways that haven't yet come to
light. Stay tuned.
Oh, and about that corrupt county attorney last year it seemed, for a
while, that corporate scandals and the obvious efforts by the
administration and some members of Congress to head off any close
scrutiny of executive evildoers would become a major political issue. But
the threat was deftly parried a few perp walks created the appearance of
reform, a new S.E.C. chairman replaced the lamentable Harvey Pitt, and
then we were in effect told to stop worrying about corporate malfeasance
and focus on the imminent threat from Saddam's W.M.D.
Now history is repeating itself. The S.E.C. ignored warnings about mutual
fund abuses, and had to be forced into action by Eliot Spitzer, the New
York attorney general. Having finally brought a fraud suit against Putnam
Investments, the S.E.C. was in a position to set a standard for future
prosecutions; sure enough, it quickly settled on terms that amount to a
gentle slap on the wrist. William Galvin, secretary of the commonwealth
of Massachusetts who is investigating Putnam, which is based in Boston
summed it up "They're not interested in exposing wrongdoing; they're
interested in giving comfort to the industry."
I wonder what they'll use to distract us this time?
New York Times -- 18 November 2003
>>>>
<<<<
TIME TO SHAKE UP FUND DIRECTORS
John Gapper
Who says craft workers in declining industries cannot adapt to
technological change? Take Local Lodge No 5 of the International
Brotherhood of Boilermakers, Iron Ship Builders, Blacksmiths, Forgers and
Helpers in New York: so flexible were 28 of its members that they learnt
to arbitrage mutual funds.
And how well they did! Each gained between $100,000 and $lm over three
years by buying and selling shares in Putnam's Voyager international
equity fund between 3pm and 4pm each day -- a time that became known as
"boilermaker hour" at Putnam's office in Norwood,
Massachusetts. It beats building iron ships.
As we now know, they were not alone in exploiting mutual fund
inefficiencies through "market timing": they joined fund
advisers and hedge funds in siphoning returns from savings and retirement
funds. Lawrence Lasser, former chief executive of Putnam Funds, is among
the fund managers who have lost their jobs as a result.
But the burgeoning market timing scandal -- potentially the worst since
the 1940 Investment Company Act that established the industry -- is not
the only reason for concern about mutual funds. A bigger worry is that
these funds are now marketed and sold to retail customers in ways that
cut returns and undermine their value as long-term investments.
Dalbar, the research group, has estimated that investors in equity funds
achieved returns of 2.6 per cent a year between 1984 and 2002, compared
with an annual return of 12.2 per cent for the S&P500 index. Given
that $7,000bn (£4,100bn) is invested in mutual funds, losses from
underperformance exceed by far the $4bn annual loss to market timing and
late trading estimated by Eric Zitzewitz of Stanford
University.
Mutual fund investors earn such poor returns for two reasons. One is the
high fees and costs: not only do investors pay management fees, and
"loads" for entering or leaving funds, but returns are reduced
by the costs of buying and selling securities. These include soft
commissions paid to brokers out of fund assets.
John Bogle, founder of Vanguard Group, estimates that funds charged
customers (also known as their shareholders) $62bn last year, of which
only $4bn was spent on investment advisory services. Mr Bogle puts the
total cost of investing in the average equity mutual fund at 2.5 to 3 per
cent of assets, which takes a substantial bite out of long-term
returns.
The second problem is the version of market timing in which mutual fund
investors increasingly indulge -- encouraged by brokers and marketing
from fund advisers. They switch funds ever more rapidly, chasing the
latest type of fund to have achieved high returns over the previous year
-- from small-cap equities to bonds.
Their own fees pay for advertisements luring them into this approach: a
symptom of an industry that, as Mr Bogle puts it, focuses increasingly on
speculation rather than investment. Not only does that raise transaction
costs -- each stock in a fund is now held for an average of only 11
months -- but rapid-fire asset allocation tends to fail
dismally.
Add all of that up, and it is not surprising that there are broad calls
for a root-and-branch reform of the industry, which invests the savings
of 95m Americans. Yet here is the oddity: in many ways, it is already
extremely well designed to prevent investors being abused. The difficulty
is that the design does not work in practice.
The theoretical beauty of the 1940 Act is that it places power in the
hands of fund investors by making them all shareholders. Each fund has a
board of directors that controls the assets, and appoints an adviser to
invest them wisely. If the advisory firm -- be it Fidelity or Putnam --
performs poorly or charges excessive fees, it can simply be replaced by
another.
In practice, as Warren Buffett succinctly put it in his letter to
Berkshire Hathaway shareholders this year: "A monkey will type out a
Shakespeare play before an 'independent' mutual fund director will
suggest that his fund look at other managers." The reality is that
advisers in effect control mutual fund boards, and, through them,
investors.
There is an ingenious argument within the mutual fund industry that all
this is as it should be. Investors choose fund managers rather than funds
and would not like it if a board of directors fired Fidelity from
managing a Fidelity fund. But if that is true (and recent events may
change investors' minds), it suggests that mutual fund boards are merely
convenient charades.
At one level, this is discouraging: there is no obvious structural way to
remedy the industry's ills if a structure exists, but is ignored. Yet it
also provides grounds for hope. If a few directors were publicly taken to
task for neglecting their duties, the others would probably wake up. Now
is the time for examples to be made pour encourager les
autres.
Financial Times -- 18 November 2003
>>>>
Keith Hudson, Bath, England,
<www.evolutionary-economics.org>
