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Tuesday, September 2, 2008

Trading Scandal's Legacy, Five Years On

'Stale-Price' Deals Cost Small Investors, But Led to Reforms

Five years ago next week, the mutual-fund world was rocked by the biggest scandal in the industry's 80-year history.

Fund companies had given certain customers trading privileges that weren't open to everyone; those special interests -- most notably some hedge funds -- engaged in rapid trading that netted quick profits at the expense of the average shareholder.

Headlines called it a "market-timing scandal," a misnomer since there is nothing illegal about trying to time the market. The problem wasn't so much the quick-fire trades as it was the special privileges that let traders play games the ordinary shareholder couldn't engage in.

The scandals centered on something called "stale-price arbitrage" in international funds. Knowing that European markets closed hours before the domestic exchanges, speculators would look for days when the broad market had risen sharply. Just before 4 p.m. in New York, the speculator would buy shares in funds with big international exposure, knowing that the foreign markets were already closed for the night; the bet was that the big day in America would trigger an equally big response abroad the next day.

Had the foreign markets already been open, market prices would have adjusted to that optimism. With the foreign markets closed, the prices were stale, creating a chance for the speculator to grab a quick profit.

The ordinary shareholder was paying the trading costs for the money moving in and out; former New York Attorney General and Gov. Eliot Spitzer said funds wouldn't put the new cash from the arbitrageur to work for days, thereby diluting any gains the fund made from the foreign exposure.

At a time when many fund investors had just lived through their first bear market and had seen their technology-laden and momentum-driven issues crushed, the public wanted the scandals to be worse than they were. They wanted the problems to explain their losses, so that they could hold someone's feet to the fire and maybe recapture their shortfall through lawsuits.

Pitching Pennies

Fast-forward five years.

The case that dramatically increased the public profile of Mr. Spitzer is now coming to its ultimate conclusion with a whimper, which has some people questioning its real significance.

Shareholders in scandal-tainted funds are starting to receive compensation for their losses. The Securities and Exchange Commission just sent checks worth a total of $40 million to 600,000 Putnam investors. An additional $18 million was distributed to some 325,000 Janus shareholders.

That is an average of roughly $66 per affected Putnam account, and about $55 per Janus shareholder. Only really big shareholders will get anything even close to those totals. The small shareholder with an IRA will be lucky to get enough payback to buy a pizza.

Over the next six months, an additional $110 million will go to Putnam shareholders, and Janus investors will see $80 million-plus in distributions. The fund firms -- and there are many others who paid fines for similar allegations -- admitted no wrongdoing but agreed to the repayment deals. In virtually every case, payouts are ready to go to shareholders in funds where rapid trading was allowed.

Compared with what investors lost to the bear market -- or what they have lost since from the mortgage crisis and credit crunch -- the settlements are minute. No one is turning the checks away, but they aren't big enough to make investors feel vindicated.

Truth be told, regulators and fund firms, along with the people hired to determine how to divvy up the fines fund companies paid, are guessing at the dollar impact of the actions.

Here is a safe bet: When the fund scandals first became public, shareholders who had been disappointed by the Putnam and Janus funds couldn't head for the exits fast enough. Chances are that scandal-tainted funds lost more money because of the run for the door than to the actual bad acts of rapid trading.

Wouldn't Happen Again?

The problems behind the scandal were easily fixed. Between prospectus changes, the addition of compliance officers, "fair-value pricing," and other behind-the-scenes moves, industry watchers say the same problem couldn't happen again today. There may be new scandals, but they will focus on some other as-yet-unaddressed loophole. Moreover, they won't involve unequal treatment, as fund companies are much more in tune with treating all shareholders alike.

In the end, industry supporters will use the small-dollar repayments to shareholders to say that the scandals were overblown. They weren't, because they showed a weakness in the system -- and in management's character -- that needed to be addressed and fixed before it was exploited further.

Clearly, investors should be more focused on performance than on back-room shenanigans, but the real legacy of the small-dollar/big-headline scandal of 2003 is that it probably saved the industry from getting into much worse, bigger problems by now.

By: Chuck Jaffe
Wall Street Journal; August 26, 2008