Thursday, November 8, 2007

Mutual Fund Scandal

This will be the last discussion of the ugly side of mutual funds for a while. After this post I will be talking about an alternative to the standard mutual fund.

I have always liked Will Rogers’ advice about investing:

“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”

There is a slight temporal problem with this strategy, but it is clear that if you could look into the future, investing would be easy. Another way to look at this quote is that you should wait until a stock goes up and then buy it at the old price. But who would be foolish enough to let you do this?

Late Trading

Back in 2003 there was a big scandal where some mutual funds allowed their preferred clients to do what is called late trading. Generally, mutual funds set the day’s price of their units when the stock market closes (4:00 pm eastern) and any trades (buying or selling of mutual fund units) during the day are executed at this price. If a trade order comes in after 4:00 pm, it is supposed to be delayed until the next day’s price. However, some funds were permitting preferred clients to make trades after 4:00 pm and still get that day’s price.

Now this may not seem like a big deal, but let’s dig a little further. Many companies wait until the stock market closes to make big announcements about events that will affect their stock to give everyone a chance to digest the news before any trading begins again. Each trade of stock has a buyer and a seller, and if the company made a positive announcement during the day, someone who heard the news first could buy some stock at a low price from someone who hadn’t heard the news. Overall, the markets run more smoothly and fairly if everyone has a chance to hear the news before trading begins.

Suppose that a mutual fund holds a lot of stock in a company that makes an announcement of unexpected good news. This will cause the mutual fund’s units to rise in value. A late-trading investor places an order at 4:20 to buy mutual fund units at the 4:00 price, and then sells these units the next day. So, the late trader puts a sum of money into the fund one day and takes out more money the next day with very little risk. The profit he makes comes directly out of the assets held by the mutual fund. All of the other investors share a loss exactly corresponding to the late trader’s profit.

Eliot Spitzer summed things up nicely: “Allowing late trading is like allowing betting on a horse race after the horses have crossed the finish line.”

To the best of my knowledge, this particular problem has been eliminated. But the fact that it happened at all illustrates that at least some mutual funds are clearly not being run for the benefit of the investors, as is required by law.

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