The Fund Scandal
Originally published May 4, 2004
Page 1
“I’m cold,” Snowden moaned. “I’m cold”
So begins one of the most memorable scenes in Joseph Heller’s novel, Catch 22.
After
dodging heavy flak on a bombing mission, Yossarian has been instructed to go the rear of the
plane to help the wounded gunner. While he busies himself dressing the wound on Snowden’s
thigh, the soldier keeps uttering this strange refrain.
“I’m cold. I’m cold.”
“There, there.” Yossarian replies, not knowing what else to say.
Time after time, they exchange these words, Yossarian above all trying to keep himself
composed as he endures Snowden’s plaintive gaze.
Finally, after watching him for a while, Snowden points his chin in the direction of the
real problem. Seeing a “strangely colored stain” seeping through Snowden’s coveralls,
Yossarian suddenly realizes that there is more at issue than the wound he has been dressing.
Heart pounding, Yossarian brings himself to rip open the snaps of Snowden’s flak suit.
He hears himself scream as he sees the full extent of Snowden’s gruesome wound.
All the while Yossarian had been dressing the wound on Snowden’s thigh, he had failed
to realize a much larger piece of flak had torn right through his midriff.
THE FUND SCANDAL
On September 3, 2003, Attorney General Eliot Spitzer announced that his office had
found evidence of “widespread illegal trading schemes” which may have cost mutual fund
shareholders billions of dollars annually. One of the perpetrators had already admitted to guilt, it
was revealed, and had agreed to pay a $10 million dollar penalty. The fraud was “complicated”
and its full extent was not known. The story was dubbed the “fund scandal” and was picked up
by all the major media. Soon chat rooms were abuzz with the latest on who had been implicated,
and how much had been pilfered from the average investor. The investigation broadened and
wound up engulfing over 30 companies including Janus, Putnam, Bank One, Strong Capital
Management, and Prudential Securities.
There are really two different problems at issue, but I will focus first on the one which
has become the currency of discussion: so called “market timing”. Small holders of mutual fund
shares were often discouraged from frequent trading, sometimes by the imposition of a fee for
“early” redemption, though in many cases the discouragement was simply part of the language of
the prospectus. In short, what the critics were saying is that the “idea” of these funds is that they
are buy and hold investments, not media for making quick profits through short term gyrations of the market. A special “class” of investors was given license to do precisely what others were
discouraged from doing. Such investors took advantage of differences between the value of the
underlying securities and the net asset value of the fund shares (especially in international funds)
to trade in and out of funds with comparative frequency.
While I agree that smaller investors should be given the same opportunities as larger
ones, I find several aspects of the charges quite bothersome. First of all, even the harshest critics
admit that few, if any, laws were broken in the case of the market timing. The notion that rapid
trading was merely “discouraged” in the language of the prospectus is quite vague. In point of
fact, few investors bother to read the prospectus anyway. Presumably any investor could have
taken advantage of discrepancies between share price and the value of the underlying securities.
The fact that a federal agency can simply decree something as wrong, and have the securities
industry roll over on its back, could have broader and troubling consequences. Second of all,
nowhere have I seen an accounting of what exactly constitutes “rapid” trading, nor any basis
upon which such a criterion might be based. The definition of “rapid” surely depends upon the
particular observer. Some investors who consider themselves buy and hold types may in fact
trade in and out of funds three to six times a year in order to increase their gains. Are these
people “market timers”? Perhaps some savvy investors with large amounts to invest trade in and
out of accounts twenty or thirty times a year. Is this materially different from what the smaller
investor is doing? Upon what basis would such a determination be made?
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