From: GreerHunt@aol.com Sent: Wednesday, December 31, 2003 6:15 PM Subject: (s7-26-03) False Reforms Will Target Ordinary Mutual-Fund Investors False Reforms Will Target Ordinary Mutual-Fund Investors Submitted to the SEC By Hunter Greer FundSense@aol.com 541-488-8528 The history of the mutual-fund industry has been a struggle between scandal and reform, between favoritism and fairness. Key events in this history were the Investment Company Act of 1940, which supposedly banned two-tier pricing, and the SEC's 1968 attempt to prohibit day-late pricing. What's new about the current recidivism is a slight increase in the sophistication of the favoritism, and what's old is a mutual-fund industry that will re-tilt the field against ordinary investors. The truth is in the details. Market Timing--Ours Any idea having negative associations but lacking a rigid definition--for example, "market timing," "communism," and "terrorism"--are invitations for insiders to manipulate public sentiment toward extraneous but self-serving goals. If regulators and self-regulators propose new, tougher rules before diligently implementing the restrictions already in place, investors should suspect ulterior motives and selective enforcement. If "market timing" is buying low and selling high, then it's the only way the little guy can make money. Insiders can cheat, advisors can siphon fees regardless of performance, but mutual-fund outsiders must buy low and sell high. If "market timing" is rapid, in-and-out trading, then penalties for such trading are already in place. The question is whether penalties should be progressive (like taxation), and whether insiders dodge them. Market Timing--Theirs One mutual-fund teleclerk volunteered that his company considers "market timing" to be the holding of shares for fewer than 30 days. According to him, customers who want to invest for 30 days or fewer should buy stocks directly. But let's follow the money. An entity that derives its profits from a percentage of the assets under management naturally prefers that investors buy and hold. The flagship fund at this particular fund family had a 2002 turnover rate of 293%. That percentage means the fund holds stocks an average of four months, longer on average than what the teleclerk calls market timing but not what I call long-term investing. If we assume an equal distribution of hold times in a portfolio having an average retention of four months, then at least 12.5% of holdings must be for less than 30 days. The percentage logically must be more than 12.5% to the extent that any holding is longer than 8 months. What we have here is market timing, management style. We know that the average stock picker or fund manager cannot beat unmanaged indices, and that the individual investor fares worse. Nevertheless, if customer market timing is better than the manager's, the fund benefits. Individuals who buy low and sell high force the fund to buy low and sell high, something the manager may not be skillful enough to do. It's true that few individual investors have the necessary ability, but it's also true that few individual investors could match the mutual-fund industry's ineptness at opening and liquidating funds--this particular fund family opened a technology fund in July of 2000 and liquidated a natural-resources (energy and gold) fund in October of 2003. What's really going on is that mutual funds don't want customer market timing to interfere with management market timing (and rake-off). Short-Hold Fees So far the public has no information on whether hedge funds (and other insiders) pay the short-retention fees that mutual funds charge ordinary investors. Whether hedge funds pay their share should be the centerpiece of every story reporting the scandal. If hedge funds do pay, in-and-out trading could be a phony issue, depending on the details. Of mutual funds that charge a fee for short holds, par is a 1% to 2% assessment for holding shares less than 30 days to a year, depending on the mutual fund. A mutual-fund daily price change of 2% happens only 10% of the time (in my sample of 27 funds for the last 12 months), so a hedge fund that pays 2% for one-day positions has to beat 90% odds just to break even. Stale prices and late trading can't overcome these odds, as I'll discuss in a later section. For now, we know that anyone making such trades is looking for a tax loss, not paying fees, or in other ways cheating sufficiently flagrantly to beat 90% odds. If mutual funds collect fees from all investors, including hedge funds, the game is potentially fair--hedges and everyone else pay their money and take their chances. The next question is whether 1-2% is too low, and whether the fee should be on a sliding scale inversely proportional to hold time. I think a one-year minimum to avoid a penalty is too harsh by a factor of six (are you listening, Scudder?), but increasing the one-day fee to cover dilution, commissions, and bureaucracy seems reasonable. Invesco used to charge fees inversely proportional to hold time, but we'll never know whether that policy worked. It's possible that an investment company offers a fund suitable for manipulation but assesses no short-hold fees, not even in the prospectus, not even for outsiders. If you know of such a fund, please let me know. Stale vs. "Fair-Value" Prices "Fair-value" pricing is first of all Orwellian newspeak, akin to "affirmative action" and "tax reform." At issue is whether US investors should be able to buy or sell, before the New York closing, mutual funds that hold Asian and European stocks whose prices are frozen at levels reflecting the earlier closes of the Asian and European markets. "Fair value"--which the SEC and mutual-fund families are touting as a remedy for staleness--interpolates prices on the basis of black-box equations and futures quotations. Quite the opposite of its name, "fair-value" pricing is fundamentally dishonest, a welcome mat for fresh insider abuses, and the mutual-fund equivalent of the software ballot box. Eric Zitzewitz, the then-Stanford professor whose academic paper alerted an Eliot Spitzer assistant, was not the first academic to publish on stale prices, but he is helping to develop a "fair value" software program, presumably for sale to mutual funds. As one might suspect, the mutual-fund industry has found an economist to accuse him of "torturing his data" to produce "spurious" results. I believe Zitzewitz (and others) are correct about the reality of stale pricing, partly because Zitzewitz made $500,000 by moving $19,500,000 in and out of funds. Nevertheless, software non-solutions are guilty until proven innocent. There's no redress for the fact that Asia and Europe will always be in non-American time zones. Picking a representative time for a "fair value" estimate isn't even possible--Asian or European mutual funds, let alone international mutual funds, comprise many markets, many zones, and many closing times. Here are the unhypothetical data that the SEC and the Wall Street Journal don't provide: The day following a 1% (B1 5% of the 1%) change in the S&P 500, a particular Asian fund finished in the same direction 73% of the time (15 data points). For a particular European fund, the rate was 50% (14 data points). In both cases the sample period was the last 12 months. If we require the non-US funds to move in the same direction by (at least) the same 1% (B1 5% of the 1%) as the S&P 500, the odds are 20% for the Asian and 0% for the European. Increasing the S&P 500 requirement to 2% (B1 5% of the 2%) gives same-direction odds of 75% for the Asian (4 data points) and 60% for the European (5 data points), but 0% for both if we require at least the same magnitude as the S&P. I don't know about you, but I couldn't make money at these odds. Once again, hedge funds that made such trades are looking for a tax write-off, not paying fees, or cheating more extravagantly than mere staleness allows. Were market-timing dilution and "fair-value" pricing already happening in these two unhypothetical funds? Two teleclerks working for the unhypothetical Asian fund required an explanation of "fair value" pricing before claiming their fund family did not do so; subsequently a press release reported that the family is being sued for not using "fair value." A teleclerk representing the unhypothetical European fund also required an explanation of "fair value" and promised to phone me with information but didn't. Meanwhile the SEC provides, and the Wall Street Journal copies, a hypothetical example in which an international mutual fund moves 10% in one day. Ten percent is a Red-baiting roundup of box-cutters. The problem is a failure of enforcement among bedfellows, not an inherent flaw in the nature of markets. Stale prices are inevitable, but the enforcement of existing (or higher) fees on short-term trading will properly limit the stale-price advantage to long-term investors who buy or sell on that particular day. Late Trading "Late trading" is a failure to enforce the daily deadline for mutual-fund transactions. Late trading is cheating and destroys the ordinary investor's confidence in the back office, but does it really give the trader an unfair advantage? My impression is that when I go to bed at 1 AM US Pacific, US futures more often than not are opposite to how they finish the US day. Since I've been formally keeping tabs, the S&P 500 futures at 1 AM Pacific correctly predicted the direction of the next-day S&P 500 US close 4 days out of 11, for 36% odds. If you have better data, please let me know. For now, I believe the bulk of business news has happened before dinner on the West Coast, not during the middle of the night. Fresh news in the morning trumps whatever happened in the wee hours. If I could get yesterday's closing price at 1 AM my time, I'd have a 12-hour advantage, but I still don't think I could make money. The biggest advantage I've seen for hedge funds is 5 hours, until 9 PM Eastern. Five hours is 6 PM Pacific, about the time of an Intel earnings report. Late-trading is not betting on a horse race that has already finished; it's a pari-mutuel window that opens early, or an early look at the paddock. Late trading is absolutely illegal, but it's of doubtful efficacy except as a Trojan horse containing Greek ulterior motives. Why are fund supermarkets (brokerages) moaning about the SEC's new "hard close"? The last I looked, supermarkets were already closing before the NYSE. In fact, early closes were the main reason I rejected supermarkets in favor of dealing with funds directly (other reasons being the supermarkets' higher fees and minimums). The obvious explanation for supermarkets' complaints is that they were letting favorites trade late. The Real Deals Are insiders' profits consistent with the scam mechanisms that the news media have described? According to Christine Dugas of USA Today (3 Dec 2003), Canary Capital Partners used a hedging strategy to make $50 million and a return of 110% on Invesco Dynamics while ordinary investors lost 34%. Excuse me? I owned Invesco Dynamics years ago, when it was a mere underperformer. How do you hedge a mutual fund--even inside and off the books? Please tell me how to profit from a decline in a mutual fund's price. Dynamics doesn't own non-US securities (if you'll pardon the expression) or junk (no pardon necessary) bonds, so stale pricing wasn't an option. Could advance knowledge of the portfolio contents convey an advantage of 144%? How late was Canary trading? Was Canary selling Dynamics short, and to whom? Until Canary sings for the rest of us, only an idiot wouldn't believe that Invesco granted Canary much more than permission to trade hours late or a day stale--we're talking at least days or weeks into the past or future. Give corporate cowboys a database, a cash flow, and no accountability (ever seen a mutual-fund annual report that wasn't "unaudited"?), and it's amazing what they can do. I'd expect something along the lines of Hillary Clinton's futures trading--conservative estimates are that Tyson Foods delivered its bribe by arranging for a brokerage to reassign her the most advantageous buys and sales, the non-celebrity brokerage customers (or Tyson itself) making up the difference. Stale prices, late trading, and peeks at the portfolio are shaping up as bones to throw investigators so they won't notice that mutual funds are masks for an orgy. False Reforms Mutual-fund crime and punishment operates at the level of my fifth-grade teacher--if someone misbehaved, nothing much happened to the perpetrator, but we all lost our recess. I predict that the public will never know whether hedge funds paid the short-hold fees that ordinary investors can't escape. Without confirmation of payment, we must assume that all three alleged improprieties--market timing, stale pricing, and late trading--will become stalking horses for increasing mutual-fund company profits. Specifically the SEC and mutual funds will agree to limit the ability of the little guy to sell shares to pay rent. Such a prohibition fits the mutual funds' goal of discouraging all withdrawals. Withdrawals reduce the amount under management and therefore the amount subject to the annual management rake-off. In other words, mutual funds will use the current crisis as a pretext to be more like Vanguard, where the opening minimum is $3,000, the ordinary invest or can sell an index fund only twice per year, and for some index funds, according to the Wall Street Journal, the ordinary investor must complete the transaction an hour and a half before the NYSE close. Putnam Investments took the early lead in admitting that insiders timed markets--and the lead in proposing new redemption fees for the general public. Janus is runner-up in both. Connect the dots. In November, 2003, William Donaldson of the SEC proposed the hiring of a chief compliance officer at each mutual-fund family, to be paid by siphoning, from ordinary investors, another million or so dollars per year (not including pension, severance, and parachute). With Donaldson's background in brokerages and the NYSE, he knows that requisitioning still another crony capitalist or majority token will not improve the personal character of the holdover company officers (whom the ideal candidate has successfully networked). Suffice it to say that the front-runner in the competition for a mutual-fund death penalty, Invesco, had a compliance officer. On the other hand, the free system already in place--whistle-blowing by lower-downs--will work just fine as soon as the Boston SEC office starts answering its phone. Everyone who doesn't have a media voice knows that company directors are lap dogs--simply follow the money. Insiders aren't fooling anyone by discussing how to make lap dogs into watch dogs. Note that the most prominent member of the Strong Funds board is Willie Davis. Were Willie Wood, Herb Adderley, Ray Nitschke, and the rest of the mutual-fund experts on the Green Bay Packers' 1960s defensive teams unable to break prior commitments? The conventional wisdom is that players on offense, not defense, are the straight arrows. In the spirit of reform, will Strong now appoint Max McGee, Boyd Dowler, and Fuzzy Thurston? Let Matt Drudge, Molly Ivins, or the woman in the street campaign for board seats; pay them from Kellogg, Brown, & Root's gasoline overcharges in Iraq; and we'll talk. Even broaching the contradiction-in-terms that is self-regulation should be grounds for a RICO prosecution. Please note, John Reed and the NYSE. The adversarial system of justice may be inappropriate for O. J. Simpson, but it's a start when both sides are who-you-know hierarchies. What exactly is "civil fraud," the charge against Invesco? Is it analogous to misdemeanor homicide? Will Invesco attempt an insanity, diabetes, or Twinkie defense? The broader threat of false reforms is to markets and capitalism. Let's review: Anyone who rents compact cars today realizes that Chrysler and GM models are indistinguishable, and that the Ford alternative offers only proprietary mannerisms. Japan has six car companies, which may be vertical trusts but not horizontal--Toyota and Mazda have real product differences. In the US we have essentially one car company, one oil company, one defense contractor, and one shoe polish--but more variation in mutual funds. The stages of capitalism are innovation, infringement, ruinous competition, monopoly, and government regulation or ownership of the monopoly. By definition, a monopoly cannot offer the best product. Hello, Bill Gates. The result of false reforms will be fewer and worse choices of mutual funds. Vanguard and Fidelity will survive, but a small, aggressive innovator won't--if such a company even exists in this copycat industry. Invesco, the fund family closest to the death penalty in early December 2003, is the company that allowed ordinary investors to open taxable no-load accounts for $250 in the late 1980s. Invesco has been shooting itself in the foot ever since--as have all mutual-fund families--but finding a company that wants the ordinary investor's business requires maximum diversity, not winnowing. Evil as Invesco has become, if it receives the death penalty, I have to pony up a higher opening minimum, fork over a sales load, or both. Eliot Spitzer should not donate his receipts to charities any more than Bill Gates should dictate who receives third-world immunizations. All fines and settlements not suitable for restitution directly to victims should go to the general fund of the prosecuting country or state. In particular, law schools are not a good choice for recipients; the good guys were lawyers, but so were the bad guys. As a lawyer and a plaintiff, Spitzer should have at minimum recused himself from charity selection. The one certainty is that prospectus-abiding investors will pay more. Trust me. Continuing Trend of Harassing Small Investors If you phoned a mutual fund in the last few years, chances are the teleclerk complained that online investing in stocks was stealing market share, that the fund family was losing the race for economies of scale, and that your $8,000 IRA balance was the root of the problem. I believed them, but it's not true. According to USA Today, the total assets of the mutual-fund industry increased every year from 1995 to 2003--except one year, from 2001 to 2002, for obvious reasons. The truth is that if assets in a particular mutual fund shrink, the cause is poor stock-picking relative to that of other mutual funds, executives who siphon amounts similar to the fired Putnam CEO's $28,000,000 in severance pay (multiply by 2 to include his stock options, pension, and other benefits), or other incompetence. I opened my mutual-fund accounts in the late 1980s for $100, $250, or $1,000--the opening minimums at that time for three mutual-fund families. Every change in family policy since then has been a new harassment of the small investor--new or higher fees for low balances, new or higher custodial charges, and a 2,400% increase in American Century's IRA opening minimum. The most egregious personal harassment was from a teleclerk who refused, because my IRA was too small, to correct computer errors in my account. He added that someone as insignificant as I was better off in bank CDs, and quoted ex-Vanguard's John Bogle on small investors' threat to profits. Second in egregiousness were two other mutual-fund teleclerks who warned me against frequent trading in funds I was selling the second time that calendar year, the shares being ones I'd held for many years. Expect the big players and rule-setters to pervert the current uproar into further attacks on the little guy. Why? Mutual funds will continue to see small accounts, not kickback-paying hedge funds, as the bigger threat to mutual funds' investment palaces and golden parachutes. Small investors are the perfect target--they own a lucrative chunk of the balance but as solitary individuals don't have the wherewithal to compete for the mutual-fund versions of Lincoln bedrooms, Gray Davis legislation, and Halliburton contracts. Florida-Style Proxy Voting Walter Hewlett's proxy fight at Hewlett-Packard showed us how companies buy votes from institutional investors. If mutual funds allow kickback-paying hedges to move rapidly in and out of mutuals, you can bet that hedges will be in mutuals when mutual-fund managers need votes. When American Century lost a proxy vote, the company changed the definition of victory--a majority of shareholders became a majority of votes cast. The Dog That Didn't Bark in Bangalore Peter Scannell, the Putnam whistle-blower, seems to be implying that his annual salary to answer the phone and enter trades on a computer hovered around $100,000--at a time when other industries contracting for similar work are paying wages appropriate to buying cooking oil in Bangalore. At the other end of Putnam's pyramid, the CEO pulled down $32,600,000 per year. Now we know why Scannell--an older, less clubable newcomer--was the first whistle-blower. News stories buried both salaries without comment. I'm not suggesting that anyone move anything to Bangalore--I recently tried to collect an auto settlement from a Bharat voice in Oklahoma--but I do mean to imply that mutual-fund incomes are appropriate to major-league baseball or confidence games, not to order entry or telephone banking. Because a look at compensation is the best way to detect a scam or even to rate a fund versus competitors, complete salary information should be in a prospectus. Management Fees Invesco's corporate parent submerged the Invesco brand name soon after wasting investors' fees on re-naming the Denver stadium. Invesco and other fund families continued to charge 12b-1 fees after closing funds to new investors. Particularly insulting is when 12b-1 fees siphoned from closed no-load funds go to brokerages and financial advisors. As mutual-fund assets have increased yearly, so have annual management fees--in total, and as a percentage of assets. If economies of scale exist, they're going to fund management, not to customers. And let's not forget Richard Grasso's long fingers. Copycat cultures, minimal competition, and lazy proxy voters leave the restoration of market forces in the mutual-fund industry to conscientious regulators or whistle-blowers. Thank you, Peter Scannell, Eliot Spitzer, and William Galvin. Real Changes Mutual-fund investors should demand respect by voting en masse against every consolidation, every liquidation, every merger, every confirmation of inside directors, every transfer agent, every advisor and subadvisor, and every manager--until the industry reduces management fees and enforces the existing rules equally for all customers. Vote against any fund proxy that doesn't itemize compensation, from executives to teleclerks. We the poor could also vote against further increases in small-account fees and minimums, but for some reason small-account fees and minimums never appear in a proxy. Now is the perfect time to try a nonprofit or credit union approach to mutual funds. As soon as I sort out the bad brokerages (25% of the largest facilitated late trading by insiders), I'll be looking at exchange-traded funds (ETFs). In the meantime, require that candidates for mutual-fund boards of directors campaign for their seats. Ask Jimmy Carter or the EU to oversee balloting. The mutual-fund scandal is a mass-market version of two-tier morality. Who must post the huge bail--Bill Gates, Kenneth Lay, or the guy who ran onto a major-league baseball field and tackled an umpire? Who goes to jail--O. J. Simpson or a black non-celebrity who's in the wrong place at the wrong time? If the amount you steal is large enough, the government offers settlement talks for civil penalties and doesn't even require an admission of wrongdoing. If your hedge fund is too large to fail, Alan Greenspan will bail it out personally. Begin these shenanigans on third base, finagle your way into the Air National Guard until you can safely go AWOL, trade oil business favors for access to your father, concoct Enron-like partnerships to hide your company's losses until you can sell before the rush, escape an investigation by using your friends at the SEC, take public money to build a stadium for your baseball team, retain good hair into your fifties--and you can become president. Let's get to work, ordinary investors and voters. Author Hunter Greer is currently compiling A Style Guide for Arguments and World Political Checklists. He may admit to developing a software program that trades mutual funds according to the prospectus. If he is, such a program has no commercial potential. Sources Bush information is from Joe Conason's Big Lies via Paul Krugman NY Rev of Books 20 Nov 2003, and from Molly Ivins' Bushwhacked. History of management fees is from Bogle Financial Markets Research Center and Lipper; via Christopher Oster and Tom Lauricella Wall Street Journal 5 Dec 2003. Allegation of 25% of brokerages is from Kathleen Day Washington Post 4 Dec 2003. Lasser at Putnam made $163 million in cash and stock, his last five years before resignation, according to Gretchen Morgenson NY Times 7 Dec 2003. Zitzewitz details are from Diana Henriques NY Times 16 Nov 2003 and Randall Smith Wall Street Journal 9 Dec 2003. Hillary Clinton's futures trading is from Spy magazine.