Mutual Fund Fraud
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MARGARET WARNER: Securities and Exchange Commission officials told today’s House hearing they expect to charge more firms in their ongoing probe into the $7 trillion mutual fund industry. Among the questionable practices being examined: Late trading — allowing a favored investor to buy fund shares at the closing price after the 4 p.m. close. That lets the investor profit from late breaking information; and market timing: Letting favored investors make quick in-and-out trades to exploit the fact that mutual funds are priced only once a day, but stock prices change constantly around the world. Average fund investors aren’t allowed to do that.
At today’s hearing, former SEC Chairman Arthur Levitt issued a harsh indictment of these and other industry practices.
ARTHUR LEVITT: Investors simply do not get what they pay for when they buy into a mutual fund, and most investors don’t even know what they’re paying for. The industry often misleads investors into buying funds on the basis of past performance. Fees, along with the effect of annual expenses, sales loads, and trading costs, are hidden. Fund directors as a whole exercise scant oversight over management. The cumulative effect of this has manifested itself in the form of late trading, market timing, and other instances of preferential treatment that cut at the very heart of investor trust. It would be hard not to conclude that the way funds are sold and managed reveals a culture that thrives on hype, promotes short-term trading, and withholds important information.
MARGARET WARNER: For more we turn to Donald Langevoort, a former special counsel at the SEC, now a professor at Georgetown Law School; and John Bogle, the founder and former CEO of the Vanguard Group, a leading mutual fund firm. He testified yesterday before a Senate subcommittee looking into the scandal. Welcome to you both.
Professor Langevoort, we heard Arthur Levitt just say that the average investor isn’t getting what he paid for. Explain to us how the average investor loses financially if some investors are getting this preferential treatment.
DONALD LANGEVOORT: Well, let’s imagine somebody is allowed to do either late trading or a market timing. Most of us, if we were invested in a technology fund, for example, and after 4 o’clock, Intel announced that orders for chips were way up, so we know tomorrow, tech fund prices –values are going to go up, we’d be able to share in that good news, the profits that come from that. Along comes some hedge fund, muscles their way in at ten minutes after 4 and gets to share in some of those profits with us. Had they not done that, we would have gotten the money. Every bit of profit they get comes out of our pockets.
MARGARET WARNER: Mr. Bogle, so how long has this been going on, and how much do you think average investors have lost cumulatively from these practices?
JOHN BOGLE: Well, it’s hard to lump them all together, but I can tell you these rapid trading practices have been going on for every bit of a decade. The idea of trading on international datelines is not a very well-kept secret. It’s been written up in financial analyst journals. And the mutual fund industry has — the time period at which mutual fund investors hold their shares used to be as long as 16 to 18 years, and now it’s two-and-a-half years. We’ve turned a great long-term investment idea into a medium for short-term speculation, and it makes no sense at all.
MARGARET WARNER: All right, let’s try to explain how this could have happened, and professor, let me start with you and start with the fund managers themselves. Why do they give certain customers this preferential treatment to engage in this?
DONALD LANGEVOORT: Well, this is the key. A fund manager, the advisor to the fund, usually is compensated based on the size of the fund. You get 1.25 percent of the assets each year as a fee. That’s where their profits come from. So they’re … what they’re interested in is the size of the fund. So if a big hedge fund comes in and says, "I’ll put $2 million in your fund if you give me preferential treatment," it’s awfully tempting for the people at the mutual fund advisor’s office to say "okay, we make money from that."
MARGARET WARNER: Mr. Bogle, is that it? The financial incentives are just the wrong way?
JOHN BOGLE: Well, it goes actually much further than that. It’s not only having the money under management. We’ve found the record is quite clear that some of these advisors were lending money at excessive interest rates to the people that were doing this trading, the advisor being — the fund manager being a bank as well. There are also a number of cases where the hedge fund would put what has come to be known as sticky assets — we have our own vocabulary now for all this. They’d put assets in the manager’s other funds where they were going to leave them for a while. So it’s three levels of payola that are going on here.
MARGARET WARNER: And what about the boards of directors, Mr. Bogle? I mean, were they just asleep at the switch or are they somehow complicit as well?
JOHN BOGLE: Well, you know, there’s an old saying that says when you have strong managers, weak directors, and passive owners, it’s only a matter of time until the looting begins. And the directors have been weakened greatly by a structural flaw in the governance of this industry, and that structural flaw is that funds don’t manage themselves. There’s an outside company that’s in the business of managing the fund. Even if the fund is $100 billion, the fund complex is $100 billion in size, it still somehow needs to go out and ask somebody to manage it for itself. And the fund shareholders don’t get adequate representation through their board of directors. That’s the crucial thing.
MARGARET WARNER: What would you add about the boards?
DONALD LANGEVOORT: The one thing I would add to it is, shareholder democracy doesn’t exist in the fund industry. We vote or we throw our proxies in the trash or whatever we do with them, but by and large, it’s the advisor who controls who the directors are. And as long as that’s the case, the problems are going to persist.
MARGARET WARNER: But do the directors also have a financial incentive in, in fact, letting some of these practices happen?
DONALD LANGEVOORT: The outside — I’m sorry. The outside directors probably don’t. Those who are affiliated with the advisors certainly do. The problem is lack of incentives. It’s that they’re asleep because the incentives simply aren’t there.
MARGARET WARNER: Mr. Bogle, you were trying to get back in.
JOHN BOGLE: No. I was just saying the amazing thing is that for anybody that’s paid attention, all of this was obvious. For example, one of the funds that was engaged in this rapid trading by shareholders, market timing, had $2 billion worth of assets, it happens, in the year 2002, and they had $9 billion worth of share liquidations. In other words, $9 billion name and $9 billion went out on a $2 billion fund. That’s a 450 percent turnover rate. That’s not a secret. It’s in their annual report. It’s in — the percentage is not there, but the dollars are in there, every –semiannually and annually each year, and all someone had to do is take the trouble to open the annual report. If the directors didn’t take the trouble to do that, I’d say shame on them.
MARGARET WARNER: And that brings up the question, Professor Langevoort, formerly of the SEC, why the regulators — if this has been so obvious, it’s been in the financial press for years, why weren’t they stopped?
DONALD LANGEVOORT: That’s a good question that the SEC is struggling to answer. To be somewhat defensive, we’ve asked the same question after Enron and WorldCom and a host of other scandals. The SEC is a small agency. There are lots of mutual funds, lots of brokers out there. Frankly, the ability of the commission to survey the industry isn’t there.
MARGARET WARNER: Do you agree, Mr. Bogle, the SEC is just outgunned?
JOHN BOGLE: Well, probably a little more charitable and perhaps even a little bit more accurate to say they’re definitely under-resourced. They haven’t had enough budgetary support and, for example, when I testified at the Senate yesterday — and the chief of the division of enforcement was there — he mentioned that a tip on the Putnam case had come into their Boston office and was ignored. He also mentioned something else, which will give you an idea of the dimension of the problem, and that is they get a thousand letters a day from fund investors saying "this is wrong" or "that is wrong," a couple hundred thousand letters a year, and it’s just almost impossible for them to have the staff to say "this is just a garden-variety complaint, or this is a nut case, or this is a very serious issue that’s been brought up here." So more resources is part of it.
MARGARET WARNER: It’s hard to sift through this, the unhappy investors who’ve lost money versus those who really have something to report. All right, so professor, what needs to be done? How to fix this?
DONALD LANGEVOORT: Well, we can fix the late- trading, market-timing issues, and already proposals are going on the table.
MARGARET WARNER: Are you talking about now legislatively or through the SEC?
DONALD LANGEVOORT: I suspect we’ll see both kinds of actions. The SEC can — it’s closing the door after the horses have left the barn, but yeah, we can have much firmer rules about what funds can and cannot do in exercising discretion over when orders are posted. It’s not going to eliminate all the problems, but it will tighten things up. The question that we really have to face up to is the more systemic one. The abuses are here in market timing and late trading now.
There are abuses in fees, brokerage activities, hundreds of places you want to look to. And you can fix this one. The question is, ought we revisit the question of directors? Is there something we can do to give the directors spine, maybe have a different kind of person, different nominating process? We certainly have to upgrade the SEC staff and make policing real. We send a letter of thanks to Eliot Spitzer for being another cop on the beat. I’m not sure there’s a single solution, but there are a lot of things that have to be done.
MARGARET WARNER: What’s your favorite remedy, Mr. Bogle?
JOHN BOGLE: We have to improve the governance system, and that will require legislation. We need — right now it’s very typical for the chairman of the board of the management company to be chairman of the board of the fund. And can you imagine? He’s negotiating with himself on the amount of fees the fund is paid. I mean, it’s absurd when you look at it that way. So that’s change one.
Number two, I think the investment advice should have no more than one seat on the fund board, to make sure it’s almost totally independent. Number three, I happen to believe that we need a federal statute of fiduciary duty, saying it is the duty of directors to make sure that funds are organized, operated, and managed — that’s the language that’s in the act now without the fiduciary duty section — in the interest of fund shareholders, rather than the interest of fund advisors and distributors. That would be a good start.
MARGARET WARNER: All right. Thank you both very much.