Jordan Goodman is the author of Everyone's Money Book, available at 888-201-6300. This is the third edition of the book. You can also visit his Web site at www.moneyanswers.com. He talks with us on Thursday mornings.

September 18, 2003

"Understanding Mutual Fund Scandal"

But that changed with the announcement from New York Attorney General Elliot Spitzer that an otherwise obscure hedge fund called Canary Capital -- and potentially other hedge funds -- had been illegally doing “late trading” in mutual funds and individual stocks. He also accused them and others of market-timing mutual funds in a way that would hurt other fund shareholders. If it turns out that these practices were widespread, it would be a major black eye for the mutual fund industry. The SEC has also demanded records from over 80 mutual fund families, and this investigation is clearly going to go on for a while.

Here is a brief explanation of what was going on here and how it might hurt you as a mutual fund shareholder:

Market-timing of mutual funds: Hedge funds like to move millions of dollars in and out of mutual funds quickly, based on their short-term market indicators. While this is not illegal, many mutual funds discourage or even ban it because it is extremely disruptive to other fund shareholders. Say, for example, a fund has $500 million in assets and all of a sudden, a hedge fund decides to sell $100 million in the fund. By law, the hedge fund is due the cash from that sale in three business days and the fund has to have the ready cash to meet that redemption. The manager either has to sell a huge number of stocks or bonds right away to raise the cash to meet that redemption or keep a lot of cash at the ready for some redemptions. Or in the opposite case, if the hedge fund wants to buy $100 million in the fund all at once, the manager has to invest a huge amount of money quickly. Either the buying or selling of fund shares in large quantity in a short period of time can make it very difficult for the fund manager to invest the way he/she wants to, instead of being ready to sell or buy shares quickly to meet these surges in cash flow. In the case of Canary, the mutual funds had restrictions on short-term trading for all investors, but apparently, those restrictions were waived for big customers like Canary. So, the interests of small investors were sacrificed for those of big-time players.

Late trading of stocks and mutual funds: The rules for trading are that the stock market closes at 4 p.m. (EDT) and if you make a trade after that, you get the price for a stock or mutual fund at the next day’s price. If you put in an order to buy a mutual fund at 3 p.m., you would get the net asset value of that fund as of 4 p.m. that day. If your order was placed at 4:05 p.m., you would get the fund’s price as of 4 p.m. the next day. Canary apparently was able to buy and sell fund shares as late as 9 p.m. and still get the pre-4 p.m. price. Of course, would be a big advantage over small investors -- if news came out after 4 p.m. that would affect the fund price significantly.

If both of these practices turn out to be widespread, there could be yet another round of investigations and scandals in the mutual fund industry -- just as investors have started to get their confidence in stocks back.

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