Fund jockeys in firing line

By MARK FRYER

By rights, these should be good times for the international fund managers who look after trillions of dollars of investors' money.

After one of the worst routs in history, sharemarkets have made solid gains and the economic future looks less frightening than it did a year ago.

But while the markets may have relented, the regulators have not. In the headquarters of the funds management business - Britain and the United States - managers are under attack for a variety of practices that the authorities claim are depriving investors of some of their rightful returns.

While the arguments are a long way away, many New Zealanders have money with the managers who are in the gun, either directly or, more probably, because many New Zealand investment organisations hire managers based in Britain or the US to look after some of their funds.

In London, the big issue is the commissions that fund managers pay to brokers.

To anyone who has bought or sold shares, commissions or brokerage seem straightforward: they are the fees you pay your broker for making the sale or purchase.

But British regulator the Financial Services Authority has latched onto the fact that many fund managers pay much more in commissions than they would if they were simply buying and selling shares.

That is because the commissions also pay for other services, such as "free" research carried out by brokers' analysts.

Some managers will promise to provide their broker with a certain amount of business each year, and pay much more than necessary, in exchange for computer equipment such as screens linked to the Bloomberg or Reuters financial information services.

Again, the extras are "free", but only because the manager is already paying in the form of commissions.

Since expenses such as commissions are deducted from a fund's returns, and ultimately come out of investors' pockets, the authority argues that investors are being made to pay some of the cost of running their manager's business, without being told what those costs are.

The authority says this creates a conflict of interest for fund managers. If they only wanted to look after their clients, the argument goes, they would hire the broker who provided the best value for money.

Instead, managers are tempted to give their business to a broker who is more expensive but offers generous extras.

The authority wants limits on the services that can be paid for through commissions, which would force managers to pay cash for things that are now "free".

The authority says this would give managers an incentive to cut costs and make a choice between research from brokers and specialist researchers.

If the changes are adopted, they are expected to affect every funds management business in Britain, as well as the brokers who work for them.

That includes unit trusts, open-ended investment companies and investment trusts - the last two of which are popular among many New Zealand investors.

Consultation on the authority's plan closed yesterday and it is not clear whether they will become law.

The plan has plenty of critics, who argue that it could make share-trading more expensive, thus eating up any saving from lower commissions, and it might encourage some managers to leave Britain altogether.

The association which speaks for the fund managers argues that if a transparent price is put on all the research, fund managers may decide they don't need so much of it, meaning the markets as a whole will become less efficient.

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Across the Atlantic, the attack on fund managers has been more dramatic, even if the underlying issues are just as obscure.

The drama comes largely from the involvement of Eliot Spitzer, the Attorney-General for the state of New York, who achieved fame when he accused some sharemarket analysts of duping investors by writing overly optimistic reports, in order to win work for their firms' investment banking operations.

In the end Spitzer triumphed, shaming some of Wall St's biggest names, forcing them to pay US$1.4 billion ($2.3 billion) and to cut some of the links between investment bankers and analysts.

Last month, Spitzer turned the heat on mutual funds (the US equivalent of our unit trusts or group investment funds), claiming that he had evidence of widespread illegal trading schemes that could potentially cost the funds' investors billions of dollars a year.

Adding to the drama is the prospect of wrongdoers being hauled off to prison.

Until now, mutual funds have largely escaped the mud that has been flung at Wall St, and research company Morningstar described Spitzer's claims as "the biggest scandal to hit the industry".

Whatever happens, his allegations are guaranteed to get plenty of publicity, if only because of the vast size of the industry. Even after the past few years, US mutual funds still have about 95 million customers with investments worth US$7 trillion - in NZ dollars that's $11,700,000,000,000.

Spitzer's claims are complex, but they boil down to an allegation that some funds allowed certain investors to buy and sell shares in those funds at favourable prices.

The chance to make an easy profit arises because of the way shares in mutual funds are priced.

Unlike company shares, that price does not change throughout the trading day. Instead, mutual fund managers set a price once a day - after the close of trading on US sharemarkets - by adding up the value of a fund's investments, then dividing by the number of shares on issue.

That price then becomes the price for any of the fund's shares bought and sold that day.

Anyone who buys or sells after the markets close gets the next day's price, which will not be known until the markets close on the following day.

But, Spitzer alleges, some funds allowed favoured investors to keep buying at the "old" price hours after the markets closed.

If that investor heard some positive news after the market closed, it could buy at the old price, confident that the fund's share price would rise the following day.

It was, said Spitzer, "like allowing betting on a horse race after the horses have crossed the finish line".

As well as "late trading", he alleged that some funds allowed "market timing" - quick in-and-out trading in the shares of funds that invest outside the US. Nimble investors could make money because time differences meant the funds' share prices were based on "stale" prices from the markets where they invested.

Any profit from those sorts of activities comes straight out of the pockets of longer-term investors, who the funds are meant to represent, and funds are meant to have rules to prevent such trading.

But Spitzer alleges that a hedge fund called Canary Capital Partners made deals with dozens of mutual fund companies.

The funds were rewarded by Canary investing millions of dollars with them, meaning more money for managers whose pay is based on the amount they manage.

Canary has agreed to pay US$40 million ($67 million), which includes restitution for its illegal profits, without admitting any wrongdoing.

The mutual fund managers named in Spitzer's accusations last month were Bank of America, Bank One, Janus Capital and Strong Capital, and others have since been implicated.

However, the deal with Canary means more revelations may be to come.

There have already been a number of sudden resignations and sackings at some mutual fund managers.

One hedge fund trader has been banned from the investment advice and mutual fund businesses for life and a former Bank of America broker faces criminal charges.

Several fund companies have hired auditors to look into allegations of wrongdoing, and Bank of America has promised to reimburse mutual fund investors who suffered because of improper trading.

The Investment Company Institute, the body that represents the mutual fund industry, has set up two taskforces to look for ways to combat late trading and market timing.

At the same time as Spitzer is looking for more scalps, the mutual fund industry is also being scrutinised by the US Securities and Exchange Commission, which is pushing for more disclosure of things such as funds' investments, the incentives paid to managers and the fees the funds charge.

Perhaps more ominously, there are signs that the scandal is having an effect where it really hurts.

The average weekly flow into sharemarket mutual funds was US$2.2 billion at the end of last month, down from US$4.9 billion a week at the end of August, according to AMG Data Services, which suggested that the fall could have something to do with investors' unease over the state of the industry.