For those of you following the US finance news, there is a developing scandal surrounding mutual funds, based on a regulatory or governance faulure. Which it would be - regulatory failure or governance failure - is a matter for individual choice.
It doesn't seem to be widely explained, but I have what might be called an inside scoop, having watched this develop over the last 6 months, so here's the story (not that I know any secrets).
Mutual funds within the US are technically unregulated. There is no designated regulator, and any regulation comes from "general jurisdiction" such as NASD's SRO status (SRO is self-regulatory-organisation) applying to the licensed broker/dealers within its ambit, or to the State Attorneys General. More about this below.
Mutual funds themselves are poorly governed. They have a bit of basic separation of roles, in that the assets held within are often held in the name of an independent party. So, that's one role of the 5PM, that which we would call the repository. But, there generally is no distinct co-signatory, and the digital side - the units in the funds - have a hotchpotch of arrangements.
IOW, governance that make the average top-notch DGC blush, as it were. One could equate the mutual fund sector to the less well governed DGCs, the ones that follow the "we don't do that, you have to trust us" mantra.
One more little thing needs to be explained: Mutual funds are not real time. Unlike DGCs, they settle in decidedly archeological time. Settlement can take months, and as long as 18 months has been seen ......
In essence, these issues are investments and you are meant to be "in" for a long time, to allow your manager to "do his thing" for you.
Of course, at some stage, the poorly liquid fund gets hit with a big redemption order. In order to satisfy redemptions, with some level of immediacy, what the mutual funds have been doing is taking on a clients that can take up the slack in the short term.
This is called "capacity." That is, if a big redemption hits, capacity is injected by a known big player, until the assets can be sold and monetarised. At which time, the big player is bought out again.
For a profit, of course. This involves some sort of good deal for the big capacity player, which is only fair, his capital is being used. In a sense, it is a bridging loan, but, as it occurs in the units of the fund, it's a bridge with a nice curve to it.
Nice, good, clean finance.
Until, that is, the managers realised that they can also benefit from letting the big players come in anytime, not just when they need the big money. Which is easy enough, as commissions are paid on th big amounts, and kickbacks are always plausible.
And this resulted in delito #1: "Market Timing."
This was a process whereby a big player and a mutual fund would negotiate a special deal to place large lumps over short periods of time, generating *two* commissions for the manager, and some big gain for the player.
In essence, it was a quantity discount, negotiated in advance.
But, in practice, it was egregious as it deliberately took money from the *other* unit holders: When the big money man saw a shift in the market, he could put a big lump in, wait a few days, and then pull it out again, knowing that others in the fund could not move as fast, and that the fund prices themselves were sticky.
However, it wasn't strictly illegal. There were no rules in the mutual fund agreement against it... So, market timing wasn't in essence something for anyone to get upset about, it was just one of those insider secrets.
Let's move on! One of the things that a mutual fund does is to mark-to-market its assets. Then, at a fixed time every day, it would declare the value of the fund, and the price of the units, based on that time and asset base.
And, as a consequence, it would also set a time by which all orders had to be in by. 3pm was common. If the order arrived after the timeslot, it got tomorrow's price.
Now comes delito #2: "Late Trading."
Unsatisfied with their bulk discounts, some players also negotiated an ability to trade *after* the cutoff time.
Which led to the perfect arbitrage. By watching a market in, say, Japan, they could see what the opening price was, after the cutoff, and if it moved favourably (to them), they could trade the fund at what was to become yesterday's price.
This was the perfect rort. Fortunes were being made. And, investors were being raped. If the trade looked good, it was confirmed at what was to be yesterday's price, and the manager would shift back the order in time. If it looked bad, it was forgotten.
All upside, no downside.
Into this fray swaggers the Attorney General of New York State. David Brown is the lead guy there, although most people will know the Attorney General as Elliot Spitzer, who is now challenging for top spot as Governor of the State of New York.
Somewhere along the end of 2002 or beginning of 2003, the AG heard whiff of crazy money being made in the mutual fund industry, and did some digging. Eventually, David Brown and his team managed to understand what was going on, and also found a case that they could take on.
That case was "Canary Capital." It was launched about mid 2003, and settled within two months for a $40 million fine and sundry banishments.
That's blinding speed in the regulatory business!
Which might indicate several things: The company got off very lightly, it was caught dead to rights, and it gave up some more info. Further, it set a precedent.
Funnily enough, Canary was an investor, and thus did not (presumably) do more than conspire to participate (and, as the settlement didn't admit blame, it maybe didn't even do that). But, even as an investor, it was sufficient to give the AG his lead case.
And now, all the big names in Wall Street are being hit with the same thing. Shocked by the crash of the first toppled domino, the whole lot are wobbling away from the vertical.
Security Trust Corp., a 13 billion dollar trust company, is being closed up by the federal government, and three executives are under indictment, facing long jail sentences (25 years, etc). A whole gaggle of famous names in the finance industry are under subpoena, and lots of hurried house cleaning operations are in progress.
It seems that almost everyone was doing it, or being done to.
Worse, big Wall Street firms were (it has been rumoured) front-running their own mutual funds! That is, one division would invest into the fund and pull out in a couple of days, generating more fees and profits for both sides.
Class action attorneys are foaming at the mouth with glee - because the investor never gets a dime of the fines, and thus, he still has a complaint! There has already been one big case launched, and the speed of it indicates that it is a strategic defence case, not a real aggresive play by injured parties.
And, of course, Elliot Spitzer has added another notch on his revolver grip, and his deputy David Brown is odds-on favourite to take the AG position.
The total fines that will be collected off Wall Street firms are rumoured to be in the order of 10 times more than the last scandal. That one set the record at 1.3 billion, so 13 billion sounds like a pretty nice haul.
Nice work if you can get it. What does it all mean to the world of DGCs? One thing is that the governance record of the unregulated mutual fund industry was pretty spotty.
To cut a long story short, the normal path for a badly governed finance sector is
1. success,
2. complaints, concerns, handwringing,
3. scandal,
4. regulation.
Mutual funds are well into phase 3. Bringing this back to DGCs, they are in phase 2. Does this mean phase 3 - scandal - follows inevitably? No, there is at least the possibility that the lesser-governed DGCs clean up their acts.
But, unless they do, any scandal will create the forces necessary to lead to regulation. As a general result. So, it's not inevitable, but one has to say that it is likely, unless there is a clean up.
I personally do not favour regulation.
(NB., that's an actual opinion, signalled explicitly, due to the rarity of such!)
To my mind, the addition of regulation causes the following sequence:
1. regulation
2. scandal
3. add more regulation, go back to 2.
But, the state of the world pertains. Which means that unless we provide a sector that can and does govern itself well, and removes the underlying (but poor) rationale for regulation, then we may well end up walking that treadmill.
iang
PS: all of the above is hearsay. I have taken no time to check the facts, and it could very well be that I've made some gross errors. These would be all mine and mine alone. I'm not "in" the MF industry, nor "in" a privileged position, so think of the above as no more than gossip. It's value is in seeing the MFs predict our own futures in advance, not in understanding the sordid details of their scandals.
PS: an earlier version of this rant was posted on the dgcchat list.
Addendum: It appears that some academic interest in the problem has occurred, with a paper by Eric Zitzewitz entitled Who Cares About Shareholders? Arbitrage Proofing Mutual Funds
See also an article at Stanford b-school The Blind Spot in Mutual Fund Investing
Posted by iang at December 5, 2003 10:37 AM | TrackBack