September 03, 2003

The Mutual Fund Industry is Cheating

Generally, I find government regulators to be sanctimonious blowhards. Most of their rhetoric about protecting small investors is cheap talk. We are all market manipulators in the sense that when we write or talk about a stock we like we are trying to get other people to buy it so the price goes up. Yet even though I think Eliot Spitzer is litigating his way to a run for public office, at least he's exposing some of the more...tawdry secrets of the fund industry. For example, the excerpt from the AP article below confirms one of the dangers that arises from the fact that mutual fund prices, unlike ETFs, change only once a day. It's left a hole wide enough for a big chunk of the industry to back up a fleet of trucks and pocket millions. The hell of it is that the firms responsible get off with what amounts to extortion from the regulating authority. In this case, it appears the actual defrauded investors will be remunerated. But generally, you see a big ol' fine and then back to business as usual. If it was you or me that got caught doing this sort of thing, we'd be going to jail, perp walk and all. Spitzer's investigation of mutual fund trading practices began earlier this year, largely focusing on techniques known as "late trading" and "market timing." "Late trading involves purchasing mutual fund shares at the 4 p.m. price after the market closes a practice equivalent to "betting on a horse race after the horses have crossed the finish line," Spitzer said. Late trading is prohibited by the Martin Act and Securities and Exchange Commission regulations. "Timing is an investment technique involving short-term, "in and out" trading of mutual fund shares, which has a detrimental effect on the long-term shareholders for whom mutual funds are designed. Timing aims to exploit market inefficiencies when the net asset value of the mutual fund shares, known as the NAV price, is set at market close, but does not reflect the current market value of the stocks held by the mutual fund. "When a market timer buys mutual fund shares at the NAV price, it realizes a profit when it sells those shares the next trading day. That profit dilutes the value of shares held by long term investors. "To allow people in after the gates have closed, when everyone else has to get back in line for the next day, is clearly not fair," said Morningstar's Phillips. "It's also likely not a case of some rogue employee's practices ... there had to be people very high up who knew what was going on. This is a real black eye for the fund industry." Shocking.


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