Themes > Current Issues
19.11.2003
A Scam on Workers Savings in the US
Jayati Ghosh
One of the
great successes of finance capital in the last decade-and
finance in American capitalism in particular-has been its
ability to draw more and more people, including workers,
into its net. Across the developed post-industrial world,
ordinary people now have a stake in how the financial
markets are doing, simply because their personal savings
for the future are invested directly or indirectly in
these markets.
This has come about through a combination of two processes. First, there is the demographic factor, resulting from a change in the structure of the population, with a greater proportion of the aged because of higher life expectancy, and a bulge of the post-war baby-boomers who are now in their prime and need to save for their old age. Second, in many countries, governments have progressively reduced their own pension and other commitments per capita, forcing more people to provide their own personal savings for the future. Just as is happening in India today, fiscal incentives for personal savings have been continuously pushed away from bank deposits towards more risky capital market instruments.
But capital markets-in securities and the like-are notoriously difficult for individual investors, and almost impossible for small investors to negotiate successfully to ensure safe and secure returns for the future. One response to this problem has been the development of mutual funds.
A mutual fund pools together the individual holdings of small personal investors and works with the total sum. A mutual fund firm invests in a broad range of stocks or other securities on behalf of a large number of individual clients. These small investors mostly purchase mutual fund shares through retirement plans or other savings plans for the future. It therefore allows small investors to diversify holdings (and thereby decrease risk) by creating a vehicle for a small amount of capital to be invested in a large number of different securities.
In the heyday of the stockmarket boom in the 1990s, these instruments were crucial in bringing many more small investors into the stockmarket, especially in the US. Today, it is estimated that the number of people investing in mutual funds in the United States is nearly 100 million, which includes around half of all households.
By now, US mutual funds alone manage as much as $7 trillion in assets, which is why these funds have become such important players in emerging markets across the world. Even a tiny shift in the portfolio, of say around 1 per cent, can cause huge movements of capital which can be deeply destabilizing for any particular emerging market. At the same time, the rapid increase of these funds over the last decade has provided a large and growing source of profit for fund owners, managers, banks and brokerage houses.
Of course, mutual funds are not limited to small investors; larger or more 'elite' investors can also invest in these. Indeed, many larger investors often prefer mutual funds as slightly safer vehicles than, say, hedge funds, which deal in large amounts of capital and are restricted to large individual investors. It is the possibility of making a difference between the millions of small investors who invest in mutual funds and the larger, more powerful or more knowledgeable investors, that is at the heart of the latest big financial scam in the US.
In October 2003, the US Securities and Exchange Commission (SEC) and state regulators in New York and Massachusetts brought charges against several large and influential mutual funds and their managers. The companies include the mutual fund giant Putnam Investments, the brokerage firm Prudential Securities, Alliance Capital Management, and a series of smaller mutual fund companies. Individual brokers and executives at some of these firms are facing criminal charges, while the mutual funds themselves face civil fraud charges.
Just as happened with Enron and the series of corporate scandals that broke out in America two years ago, the matter is now snowballing as more and more firms get implicated. What began as an enquiry against a single hedge fund by the New York regulator Eliot Spitzer (who was also instrumental in prosecuting the Arthur Anderson accounting company during the Enron scandal) has now engulfed almost the entire mutual fund business.
The basic accusations concern 'market-timing' and illegal late trading of mutual fund shares, both of which benefit an elite group of investors and fund managers at the expense of millions of small investors. These are manipulations were made possible by the peculiar way in which mutual funds are priced.
Unlike many other stockmarket-based financial instruments, mutual funds are not priced continuously on the market. Instead, at the end of each trading day (4 pm Eastern Standard Time), the total value of the fund's investments is calculated and this figure is divided by the number of outstanding fund shares, yielding the price per share. An order to buy or sell a share in a mutual fund is held until the end of the day, when it is processed at the closing price. The purpose of this is to prevent investors from taking advantage of the very temporary movements in price over the day.
However, this has created the possibility of 'market-timing', a process by which an investor takes advantage of the fact that the price of a mutual fund is determined by the closing value of the shares owned by the fund, regardless of when this closing value was actually determined. Thus, for example, international stocks and shares owned by the fund are priced at the value of the stock at the time of the closing of the market in which they are traded, which can be hours before the closing of the US markets. This is true of all Asian and European stocks, for example.
Since there are such large time differences involved with markets closing at very different times across the world, there could be events or information that come through to reveal to investors that the actual value of the international shares is different from the closing (or 'stale') value. Therefore, the real value of the mutual fund may be quite different from the calculated value at the close of the trading day. This provides a tremendous opportunity for profit, especially for insiders of fund managers, who can take advantage of information that is not available to ordinary retail investors.
The other practice that has been used to deprive small investors of returns at the cost of a favoured group of insiders of elite investors is known as late trading. In this case, managers can benefit selected clients by processing orders as if they were placed before the close of the trading day instead of later. This is possible because orders usually take several hours to process, so that trades are usually allowed to go through to the mutual fund well after closing, as long as the original order was placed before the close of the trading day. So brokers can simply declare that a particular order was placed earlier. Late trading is more than a bending of the law, it is strictly illegal although extremely difficult to monitor and regulate.
Both market-timing and late trading do more than provide windfall profits for a small group of favoured investors or even insider managers themselves. They also affect the total value of the mutual fund and therefore the return to small investors. Whenever an investor sells at a price above the true market value of the fund's shares or buys at a price below the market value, the difference must be absorbed by the mutual fund itself. This means that the total value of the assets owned by the fund, and therefore the value of each individual holding, must go down.
It is now clear that these practices were not restricted to a few unscrupulous mutual fund managers, but were actually widespread across the hedge fund and mutual fund industries. Every week since September, when the first accusations against a hedge fund were made by Eliot Spitzer, new firms have come up for scrutiny and been found wanting. Clearly, therefore, millions of small investors in the US who invested in mutual funds have lost some savings by virtue of these sharp practices.
The SEC has already been criticized for its inactivity and ignoring of such fraudulent practices, which raise many parallels with the earlier Wall Street scams. A recent settlement of SEC with Putnam, the fifth biggest US fund manager, has been denounced by Spitzer and other regulators for not going far enough. Without admitting wrongdoing, Putnam has agreed to 'governance reforms' and to pay restitution to investors who lost money as a result of its employees' improper trading. This is tantamount to administering a light slap on the wrist for very serious financial crimes.
While some individual managers are being punished by losing their jobs, the extent of punishment is not likely to be a deterrent to such activity by others in the future. This is especially true when those who are forced to leave still make windfall gains in the process. For example, the CEO of Putnam, Lawrence Lasser, is due to receive $89 million in parting pay. He was already one of the highest paid executives in the industry, receiving over $100 million in pay and bonuses over the past five years.
All this reinforces arguments that are now well known: that financial markets are prone to all sorts of imperfections resulting from incomplete and asymmetric information in particular, and that these can give rise to very serious malfunctioning and wrongdoing. It is also increasingly clear that adequately regulating undesirable practices is difficult if not impossible, given the ability of the markets to develop new forms of malpractice, and the close social and political nexus that tends to exist between financiers and those who are meant to monitor them.
This has come about through a combination of two processes. First, there is the demographic factor, resulting from a change in the structure of the population, with a greater proportion of the aged because of higher life expectancy, and a bulge of the post-war baby-boomers who are now in their prime and need to save for their old age. Second, in many countries, governments have progressively reduced their own pension and other commitments per capita, forcing more people to provide their own personal savings for the future. Just as is happening in India today, fiscal incentives for personal savings have been continuously pushed away from bank deposits towards more risky capital market instruments.
But capital markets-in securities and the like-are notoriously difficult for individual investors, and almost impossible for small investors to negotiate successfully to ensure safe and secure returns for the future. One response to this problem has been the development of mutual funds.
A mutual fund pools together the individual holdings of small personal investors and works with the total sum. A mutual fund firm invests in a broad range of stocks or other securities on behalf of a large number of individual clients. These small investors mostly purchase mutual fund shares through retirement plans or other savings plans for the future. It therefore allows small investors to diversify holdings (and thereby decrease risk) by creating a vehicle for a small amount of capital to be invested in a large number of different securities.
In the heyday of the stockmarket boom in the 1990s, these instruments were crucial in bringing many more small investors into the stockmarket, especially in the US. Today, it is estimated that the number of people investing in mutual funds in the United States is nearly 100 million, which includes around half of all households.
By now, US mutual funds alone manage as much as $7 trillion in assets, which is why these funds have become such important players in emerging markets across the world. Even a tiny shift in the portfolio, of say around 1 per cent, can cause huge movements of capital which can be deeply destabilizing for any particular emerging market. At the same time, the rapid increase of these funds over the last decade has provided a large and growing source of profit for fund owners, managers, banks and brokerage houses.
Of course, mutual funds are not limited to small investors; larger or more 'elite' investors can also invest in these. Indeed, many larger investors often prefer mutual funds as slightly safer vehicles than, say, hedge funds, which deal in large amounts of capital and are restricted to large individual investors. It is the possibility of making a difference between the millions of small investors who invest in mutual funds and the larger, more powerful or more knowledgeable investors, that is at the heart of the latest big financial scam in the US.
In October 2003, the US Securities and Exchange Commission (SEC) and state regulators in New York and Massachusetts brought charges against several large and influential mutual funds and their managers. The companies include the mutual fund giant Putnam Investments, the brokerage firm Prudential Securities, Alliance Capital Management, and a series of smaller mutual fund companies. Individual brokers and executives at some of these firms are facing criminal charges, while the mutual funds themselves face civil fraud charges.
Just as happened with Enron and the series of corporate scandals that broke out in America two years ago, the matter is now snowballing as more and more firms get implicated. What began as an enquiry against a single hedge fund by the New York regulator Eliot Spitzer (who was also instrumental in prosecuting the Arthur Anderson accounting company during the Enron scandal) has now engulfed almost the entire mutual fund business.
The basic accusations concern 'market-timing' and illegal late trading of mutual fund shares, both of which benefit an elite group of investors and fund managers at the expense of millions of small investors. These are manipulations were made possible by the peculiar way in which mutual funds are priced.
Unlike many other stockmarket-based financial instruments, mutual funds are not priced continuously on the market. Instead, at the end of each trading day (4 pm Eastern Standard Time), the total value of the fund's investments is calculated and this figure is divided by the number of outstanding fund shares, yielding the price per share. An order to buy or sell a share in a mutual fund is held until the end of the day, when it is processed at the closing price. The purpose of this is to prevent investors from taking advantage of the very temporary movements in price over the day.
However, this has created the possibility of 'market-timing', a process by which an investor takes advantage of the fact that the price of a mutual fund is determined by the closing value of the shares owned by the fund, regardless of when this closing value was actually determined. Thus, for example, international stocks and shares owned by the fund are priced at the value of the stock at the time of the closing of the market in which they are traded, which can be hours before the closing of the US markets. This is true of all Asian and European stocks, for example.
Since there are such large time differences involved with markets closing at very different times across the world, there could be events or information that come through to reveal to investors that the actual value of the international shares is different from the closing (or 'stale') value. Therefore, the real value of the mutual fund may be quite different from the calculated value at the close of the trading day. This provides a tremendous opportunity for profit, especially for insiders of fund managers, who can take advantage of information that is not available to ordinary retail investors.
The other practice that has been used to deprive small investors of returns at the cost of a favoured group of insiders of elite investors is known as late trading. In this case, managers can benefit selected clients by processing orders as if they were placed before the close of the trading day instead of later. This is possible because orders usually take several hours to process, so that trades are usually allowed to go through to the mutual fund well after closing, as long as the original order was placed before the close of the trading day. So brokers can simply declare that a particular order was placed earlier. Late trading is more than a bending of the law, it is strictly illegal although extremely difficult to monitor and regulate.
Both market-timing and late trading do more than provide windfall profits for a small group of favoured investors or even insider managers themselves. They also affect the total value of the mutual fund and therefore the return to small investors. Whenever an investor sells at a price above the true market value of the fund's shares or buys at a price below the market value, the difference must be absorbed by the mutual fund itself. This means that the total value of the assets owned by the fund, and therefore the value of each individual holding, must go down.
It is now clear that these practices were not restricted to a few unscrupulous mutual fund managers, but were actually widespread across the hedge fund and mutual fund industries. Every week since September, when the first accusations against a hedge fund were made by Eliot Spitzer, new firms have come up for scrutiny and been found wanting. Clearly, therefore, millions of small investors in the US who invested in mutual funds have lost some savings by virtue of these sharp practices.
The SEC has already been criticized for its inactivity and ignoring of such fraudulent practices, which raise many parallels with the earlier Wall Street scams. A recent settlement of SEC with Putnam, the fifth biggest US fund manager, has been denounced by Spitzer and other regulators for not going far enough. Without admitting wrongdoing, Putnam has agreed to 'governance reforms' and to pay restitution to investors who lost money as a result of its employees' improper trading. This is tantamount to administering a light slap on the wrist for very serious financial crimes.
While some individual managers are being punished by losing their jobs, the extent of punishment is not likely to be a deterrent to such activity by others in the future. This is especially true when those who are forced to leave still make windfall gains in the process. For example, the CEO of Putnam, Lawrence Lasser, is due to receive $89 million in parting pay. He was already one of the highest paid executives in the industry, receiving over $100 million in pay and bonuses over the past five years.
All this reinforces arguments that are now well known: that financial markets are prone to all sorts of imperfections resulting from incomplete and asymmetric information in particular, and that these can give rise to very serious malfunctioning and wrongdoing. It is also increasingly clear that adequately regulating undesirable practices is difficult if not impossible, given the ability of the markets to develop new forms of malpractice, and the close social and political nexus that tends to exist between financiers and those who are meant to monitor them.
© MACROSCAN 2003