Vile Practice: From the Shady to the Criminally Fraudulent

In 2003 we were reminded that much of the mutual fund industry has suffered the taint of unethical practices which put the interests of one class of client above the interest of another class of client. The scandals or 2003 were the worse we had seen in the US for years, but they were no where near either historical or global records. Where there are piles of money, people are led into temptations.

Headline Examples

"Market Timing"

In this context, "market timing" means permitting a hedge fund to make frequent trades in the mutual fund while telling the run-of-the-mill client that such frequent trading is not allowed. The effect of this is that the run-of-the-mill client ends up paying the lion's share of the extra trading costs caused by the hedge funds hyper-activity. Some big name mutual fund engaged in this practice for extra compensation from the hedge funds --- either direct or indirect. This is obviously an unethical practice, but before the courts held that this kind of "market timing" is an illegal practice, it was widely practiced.

"Late Trading"

A purchase or sale in an open-ended mutual fund made during the day is transacted at 4:00pm at the Net Asset Value of fund. Some funds permitted favored clients to trade at the same NAV at times later than 4:00pm. This gave the favored clients a substantial betting edge. The net effect was to bleed asset value from the non-favored clients.

Late trading, or more generally, trading stale prices, has a long history. In an earlier form, it was on of the bad practices that Joe Kennedy tried to stop when serving as the first head of the SEC.

(Resources: The venerable Wiki on the 2003 Mutual Fund Scandals)

"Soft Money"

Soft money was an almost standard business practice in the US for many years, and it is still a common practice in many parts of the world. In this practice, the fund "pays" for research (or telephones or Bloomberg machines) by placing trades through the broker who provided the research (or telephones or Bloomberg machines).

So what's not right about that? Well the fund has expenses (like payroll) which the fund share holders expect the fund managers to pay out of their management fee. The fund shareholders have the right to expect that other expenses --- like research (or telephones or Bloomberg machines) --- would likewise come out of the management fee. What soft money does is suck these fund expenses out of the returns on the fund investments. The investor loses, and the fund provider wins.

To those with a strong moral compass, this looks at least fishy enough to deserve to be explained carefully in the fund prospectus. This was mostly done, and "soft money" was mostly non-criminal --- though hardly investor friendly. Also, there were firms that stepped over the line and which were fined. Still, the fines have so far made up only the most trivial part of the value that was transferred from investors to fund managers over many decades.

"Stock Lending --- Who Gets the Fee?"

Short selling is a good thing; it helps to keep markets efficient. To make short selling possible, one has to be able to borrow stocks. Mutual funds are often the lenders, and they received a fee for this service.

Who deserves the fee --- the fund managers or the fund investors?

I think a case can be made that the fee should be split. The investors provided the capital but the managers provide a value-added service. In fact, most prospectuses say something like "from time to time the fund may receive fees for lending stocks. These fees are used to help to defray the expenses of the fund."

Now think for a second. Is this sentence any different than "the management stuffs the money in its pocket"? None at all. The management was already on the hook for the expenses.

Still, it is industry practice that the "managers keep the fee" and perhaps if this is kept in mind when they set their stated management fee, then all is fair. To be sure, this is an legal and universal practice, with just the smallest wink of non-disclosure.

Lesser Known Examples

"Marking the Close"

Consider a fund that has a substantial part of its portfolio in thinly traded stocks. At the end of the quarter, the manager makes big additional buys of these stocks. The prices are pushed up, and the manager gets to post a "good quarter." Naturally, the thinly traded shares go back down very shortly and value has been transferred from the fund holders to the trading counter party. The fund investors have suffered greatly just so the manager could "post another good quarter." This is a really stupid (i.e. short sighted) thing to do, but it has been done.

(see SEC compliant vs Michael Lauer and Lancer Management Group)

"Front Running the Order Book"

Classic "front running" is the act of a broker selling his shares before selling the customer's shares. This has been a firing offence since the 1930's --- though it was common practice in the US before then and may well be the practice in some parts of the world today.

There is a modern version that is more of a risk arbitrage. It is not illegal (to my knowledge) but it seems to me to be of dubious ethics.

Suppose someone puts a big sell order on your book for 1,000,000 shares at 50 when the market is at 49.75. You immediately go ahead an sell short 10,000 at 49.75. This is not quite classic front running since the order on your book is not a "alive" until the price hits 50.

Now, pretend that the market is efficient and look at what happens. If the market goes way down, your short makes a lot of money, yippee! If the market starts to go up, it bumps ito the big sell order at 50 and the price has a very hard time going any higher. You have time to get out, losing very little, if anything. Heads you win, tails you don't lose.

I do not know the industry wisdom about this old trick. It may have been rendered obsolete by ECNs or other developments. It may have been made explicitly in appropriate by revisions of the classic "front running" rule. I do know that the "technique" is widely known and at times passed was widely practiced.


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