From: GreerHunt@aol.com
Sent: Wednesday, December 31, 2003 6:15 PM
Subject: (s7-26-03) False Reforms Will Target Ordinary Mutual-Fund
Investors

False Reforms Will Target Ordinary Mutual-Fund Investors

Submitted to the SEC

By Hunter Greer   FundSense@aol.com   541-488-8528

The history of the mutual-fund industry has been a struggle between scandal
and reform, between favoritism and fairness.  Key events in this history were
the Investment Company Act of 1940, which supposedly banned two-tier pricing,
and the SEC's 1968 attempt to prohibit day-late pricing.  What's new about the
current recidivism is a slight increase in the sophistication of the
favoritism, and what's old is a mutual-fund industry that will re-tilt the field
against ordinary investors.  The truth is in the details.

Market Timing--Ours

Any idea having negative associations but lacking a rigid definition--for
example, "market timing," "communism," and "terrorism"--are invitations for
insiders to manipulate public sentiment toward extraneous but self-serving goals. 
If regulators and self-regulators propose new, tougher rules before diligently
implementing the restrictions already in place, investors should suspect
ulterior motives and selective enforcement.

If "market timing" is buying low and selling high, then it's the only way the
little guy can make money.  Insiders can cheat, advisors can siphon fees
regardless of performance, but mutual-fund outsiders must buy low and sell high.

If "market timing" is rapid, in-and-out trading, then penalties for such
trading are already in place.  The question is whether penalties should be
progressive (like taxation), and whether insiders dodge them.

Market Timing--Theirs

One mutual-fund teleclerk volunteered that his company considers "market
timing" to be the holding of shares for fewer than 30 days.  According to him,
customers who want to invest for 30 days or fewer should buy stocks directly. 
But let's follow the money.  An entity that derives its profits from a
percentage of the assets under management naturally prefers that investors buy and
hold. 

The flagship fund at this particular fund family had a 2002 turnover rate of
293%.  That percentage means the fund holds stocks an average of four months,
longer on average than what the teleclerk calls market timing but not what I
call long-term investing.  If we assume an equal distribution of hold times in
a portfolio having an average retention of four months, then at least 12.5% of
holdings must be for less than 30 days.  The percentage logically must be
more than 12.5% to the extent that any holding is longer than 8 months.  What we
have here is market timing, management style.

We know that the average stock picker or fund manager cannot beat unmanaged
indices, and that the individual investor fares worse.  Nevertheless, if
customer market timing is better than the manager's, the fund benefits.  Individuals
who buy low and sell high force the fund to buy low and sell high, something
the manager may not be skillful enough to do.  It's true that few individual
investors have the necessary ability, but it's also true that few individual
investors could match the mutual-fund industry's ineptness at opening and
liquidating funds--this particular fund family opened a technology fund in July of
2000 and liquidated a natural-resources (energy and gold) fund in October of 2003.

What's really going on is that mutual funds don't want customer market timing
to interfere with management market timing (and rake-off).

Short-Hold Fees

So far the public has no information on whether hedge funds (and other
insiders) pay the short-retention fees that mutual funds charge ordinary investors. 
Whether hedge funds pay their share should be the centerpiece of every story
reporting the scandal.  If hedge funds do pay, in-and-out trading could be a
phony issue, depending on the details.

Of mutual funds that charge a fee for short holds, par is a 1% to 2%
assessment for holding shares less than 30 days to a year, depending on the mutual
fund.  A mutual-fund daily price change of 2% happens only 10% of the time (in my
sample of 27 funds for the last 12 months), so a hedge fund that pays 2% for
one-day positions has to beat 90% odds just to break even.  Stale prices and
late trading can't overcome these odds, as I'll discuss in a later section.
For now, we know that anyone making such trades is looking for a tax loss, not
paying fees, or in other ways cheating sufficiently flagrantly to beat 90% odds.

If mutual funds collect fees from all investors, including hedge funds, the
game is potentially fair--hedges and everyone else pay their money and take
their chances.  The next question is whether 1-2% is too low, and whether the fee
should be on a sliding scale inversely proportional to hold time.  I think a
one-year minimum to avoid a penalty is too harsh by a factor of six (are you
listening, Scudder?), but increasing the one-day fee to cover dilution,
commissions, and bureaucracy seems reasonable.  Invesco used to charge fees
inversely proportional to hold time, but we'll never know whether that policy 
worked.

It's possible that an investment company offers a fund suitable for
manipulation but assesses no short-hold fees, not even in the prospectus, not 
even for outsiders.  If you know of such a fund, please let me know.

Stale vs. "Fair-Value" Prices

"Fair-value" pricing is first of all Orwellian newspeak, akin to "affirmative
action" and "tax reform."

At issue is whether US investors should be able to buy or sell, before the
New York closing, mutual funds that hold Asian and European stocks whose prices
are frozen at levels reflecting the earlier closes of the Asian and European
markets.

"Fair value"--which the SEC and mutual-fund families are touting as a remedy
for staleness--interpolates prices on the basis of black-box equations and
futures quotations.  Quite the opposite of its name, "fair-value" pricing is
fundamentally dishonest, a welcome mat for fresh insider abuses, and the
mutual-fund equivalent of the software ballot box.

Eric Zitzewitz, the then-Stanford professor whose academic paper alerted an
Eliot Spitzer assistant, was not the first academic to publish on stale prices,
but he is helping to develop a "fair value" software program, presumably for
sale to mutual funds.  As one might suspect, the mutual-fund industry has
found an economist to accuse him of "torturing his data" to produce "spurious"
results.  I believe Zitzewitz (and others) are correct about the reality of stale
pricing, partly because Zitzewitz made $500,000 by moving $19,500,000 in and
out of funds.  Nevertheless, software non-solutions are guilty until proven
innocent.

There's no redress for the fact that Asia and Europe will always be in
non-American time zones.  Picking a representative time for a "fair value" 
estimate isn't even possible--Asian or European mutual funds, let alone 
international mutual funds, comprise many markets, many zones, and many closing 
times.

Here are the unhypothetical data that the SEC and the Wall Street Journal
don't provide:  The day following a 1% (B1 5% of the 1%) change in the S&P 500, a
particular Asian fund finished in the same direction 73% of the time (15 data
points).  For a particular European fund, the rate was 50% (14 data points).
 
In both cases the sample period was the last 12 months.  If we require the
non-US funds to move in the same direction by (at least) the same 1% (B1 5% of the
1%) as the S&P 500, the odds are 20% for the Asian and 0% for the European.

Increasing the S&P 500 requirement to 2% (B1 5% of the 2%) gives same-direction
odds of 75% for the Asian (4 data points) and 60% for the European (5 data
points), but 0% for both if we require at least the same magnitude as the S&P. 
I don't know about you, but I couldn't make money at these odds.  Once again,
hedge funds that made such trades are looking for a tax write-off, not paying
fees, or cheating more extravagantly than mere staleness allows.

Were market-timing dilution and "fair-value" pricing already happening in
these two unhypothetical funds?  Two teleclerks working for the unhypothetical
Asian fund required an explanation of "fair value" pricing before claiming their
fund family did not do so; subsequently a press release reported that the
family is being sued for not using "fair value."  A teleclerk representing the
unhypothetical European fund also required an explanation of "fair value" and
promised to phone me with information but didn't.

Meanwhile the SEC provides, and the Wall Street Journal copies, a
hypothetical example in which an international mutual fund moves 10% in one day.  
Ten percent is a Red-baiting roundup of box-cutters.

The problem is a failure of enforcement among bedfellows, not an inherent
flaw in the nature of markets.  Stale prices are inevitable, but the enforcement
of existing (or higher) fees on short-term trading will properly limit the
stale-price advantage to long-term investors who buy or sell on that particular
day.

Late Trading

"Late trading" is a failure to enforce the daily deadline for mutual-fund
transactions.

Late trading is cheating and destroys the ordinary investor's confidence in
the back office, but does it really give the trader an unfair advantage?  My
impression is that when I go to bed at 1 AM US Pacific, US futures more often
than not are opposite to how they finish the US day.  Since I've been formally
keeping tabs, the S&P 500 futures at 1 AM Pacific correctly predicted the
direction of the next-day S&P 500 US close 4 days out of 11, for 36% odds. If you
have better data, please let me know.  For now, I believe the bulk of business
news has happened before dinner on the West Coast, not during the middle of
the night.  Fresh news in the morning trumps whatever happened in the wee
hours.  If I could get yesterday's closing price at 1 AM my time, I'd have a
12-hour advantage, but I still don't think I could make money.  The biggest
advantage I've seen for hedge funds is 5 hours, until 9 PM Eastern.  Five hours 
is 6 PM Pacific, about the time of an Intel earnings report.

Late-trading is not betting on a horse race that has already finished; it's a
pari-mutuel window that opens early, or an early look at the paddock.  Late
trading is absolutely illegal, but it's of doubtful efficacy except as a Trojan
horse containing Greek ulterior motives.

Why are fund supermarkets (brokerages) moaning about the SEC's new "hard
close"?  The last I looked, supermarkets were already closing before the NYSE.  In
fact, early closes were the main reason I rejected supermarkets in favor of
dealing with funds directly (other reasons being the supermarkets' higher fees
and minimums).  The obvious explanation for supermarkets' complaints is that
they were letting favorites trade late.

The Real Deals

Are insiders' profits consistent with the scam mechanisms that the news media
have described?  According to Christine Dugas of USA Today (3 Dec 2003),
Canary Capital Partners used a hedging strategy to make $50 million and a return
of 110% on Invesco Dynamics while ordinary investors lost 34%.

Excuse me?  I owned Invesco Dynamics years ago, when it was a mere
underperformer.  How do you hedge a mutual fund--even inside and off the books?  
Please tell me how to profit from a decline in a mutual fund's price.  Dynamics
doesn't own non-US securities (if you'll pardon the expression) or junk (no pardon
necessary) bonds, so stale pricing wasn't an option.  Could advance knowledge
of the portfolio contents convey an advantage of 144%?  How late was Canary
trading?  Was Canary selling Dynamics short, and to whom?

Until Canary sings for the rest of us, only an idiot wouldn't believe that
Invesco granted Canary much more than permission to trade hours late or a day
stale--we're talking at least days or weeks into the past or future.  Give
corporate cowboys a database, a cash flow, and no accountability (ever seen a
mutual-fund annual report that wasn't "unaudited"?), and it's amazing what they can
do.  I'd expect something along the lines of Hillary Clinton's futures
trading--conservative estimates are that Tyson Foods delivered its bribe by
arranging for a brokerage to reassign her the most advantageous buys and sales, the
non-celebrity brokerage customers (or Tyson itself) making up the difference.

Stale prices, late trading, and peeks at the portfolio are shaping up as
bones to throw investigators so they won't notice that mutual funds are masks for
an orgy.

False Reforms

Mutual-fund crime and punishment operates at the level of my fifth-grade
teacher--if someone misbehaved, nothing much happened to the perpetrator, but we
all lost our recess.

I predict that the public will never know whether hedge funds paid the
short-hold fees that ordinary investors can't escape.  Without confirmation of
payment, we must assume that all three alleged improprieties--market timing, stale
pricing, and late trading--will become stalking horses for increasing
mutual-fund company profits. 

Specifically the SEC and mutual funds will agree to limit the ability of the
little guy to sell shares to pay rent.  Such a prohibition fits the mutual
funds' goal of discouraging all withdrawals.  Withdrawals reduce the amount under
management and therefore the amount subject to the annual management rake-off.

In other words, mutual funds will use the current crisis as a pretext to be
more like Vanguard, where the opening minimum is $3,000, the ordinary invest or
can sell an index fund only twice per year, and for some index funds,
according to the Wall Street Journal, the ordinary investor must complete the
transaction an hour and a half before the NYSE close.

Putnam Investments took the early lead in admitting that insiders timed
markets--and the lead in proposing new redemption fees for the general public. 
Janus is runner-up in both.  Connect the dots.

In November, 2003, William Donaldson of the SEC proposed the hiring of a
chief compliance officer at each mutual-fund family, to be paid by siphoning, from
ordinary investors, another million or so dollars per year (not including
pension, severance, and parachute).  With Donaldson's background in brokerages
and the NYSE, he knows that requisitioning still another crony capitalist or
majority token will not improve the personal character of the holdover company
officers (whom the ideal candidate has successfully networked).  Suffice it to
say that the front-runner in the competition for a mutual-fund death penalty,
Invesco, had a compliance officer.  On the other hand, the free system already
in place--whistle-blowing by lower-downs--will work just fine as soon as the

Boston SEC office starts answering its phone.

Everyone who doesn't have a media voice knows that company directors are lap
dogs--simply follow the money.  Insiders aren't fooling anyone by discussing
how to make lap dogs into watch dogs.  Note that the most prominent member of
the Strong Funds board is Willie Davis.  Were Willie Wood, Herb Adderley, Ray
Nitschke, and the rest of the mutual-fund experts on the Green Bay Packers'
1960s defensive teams unable to break prior commitments?  The conventional wisdom
is that players on offense, not defense, are the straight arrows.  In the
spirit of reform, will Strong now appoint Max McGee, Boyd Dowler, and Fuzzy
Thurston?  Let Matt Drudge, Molly Ivins, or the woman in the street campaign for
board seats; pay them from Kellogg, Brown, & Root's gasoline overcharges in
Iraq; and we'll talk.

Even broaching the contradiction-in-terms that is self-regulation should be
grounds for a RICO prosecution.  Please note, John Reed and the NYSE.  The
adversarial system of justice may be inappropriate for O. J. Simpson, but it's a
start when both sides are who-you-know hierarchies.

What exactly is "civil fraud," the charge against Invesco?  Is it analogous
to misdemeanor homicide?  Will Invesco attempt an insanity, diabetes, or
Twinkie defense?

The broader threat of false reforms is to markets and capitalism.  Let's
review:  Anyone who rents compact cars today realizes that Chrysler and GM models
are indistinguishable, and that the Ford alternative offers only proprietary
mannerisms.  Japan has six car companies, which may be vertical trusts but not
horizontal--Toyota and Mazda have real product differences.  In the US we have
essentially one car company, one oil company, one defense contractor, and one
shoe polish--but more variation in mutual funds.  The stages of capitalism
are innovation, infringement, ruinous competition, monopoly, and government
regulation or ownership of the monopoly.  By definition, a monopoly cannot offer
the best product.  Hello, Bill Gates.

The result of false reforms will be fewer and worse choices of mutual funds. 
Vanguard and Fidelity will survive, but a small, aggressive innovator
won't--if such a company even exists in this copycat industry.  Invesco, the fund
family closest to the death penalty in early December 2003, is the company that
allowed ordinary investors to open taxable no-load accounts for $250 in the
late 1980s.  Invesco has been shooting itself in the foot ever since--as have all
mutual-fund families--but finding a company that wants the ordinary
investor's business requires maximum diversity, not winnowing.  Evil as Invesco has
become, if it receives the death penalty, I have to pony up a higher opening
minimum, fork over a sales load, or both.

Eliot Spitzer should not donate his receipts to charities any more than Bill
Gates should dictate who receives third-world immunizations.  All fines and
settlements not suitable for restitution directly to victims should go to the
general fund of the prosecuting country or state.  In particular, law schools
are not a good choice for recipients; the good guys were lawyers, but so were
the bad guys.  As a lawyer and a plaintiff, Spitzer should have at minimum
recused himself from charity selection. 

The one certainty is that prospectus-abiding investors will pay more.  Trust
me.

Continuing Trend of Harassing Small Investors

If you phoned a mutual fund in the last few years, chances are the teleclerk
complained that online investing in stocks was stealing market share, that the
fund family was losing the race for economies of scale, and that your $8,000
IRA balance was the root of the problem.  I believed them, but it's not true.

According to USA Today, the total assets of the mutual-fund industry
increased every year from 1995 to 2003--except one year, from 2001 to 2002, for
obvious reasons.  The truth is that if assets in a particular mutual fund shrink,
the cause is poor stock-picking relative to that of other mutual funds,
executives who siphon amounts similar to the fired Putnam CEO's $28,000,000 in
severance pay (multiply by 2 to include his stock options, pension, and other
benefits), or other incompetence.

I opened my mutual-fund accounts in the late 1980s for $100, $250, or
$1,000--the opening minimums at that time for three mutual-fund families.  Every
change in family policy since then has been a new harassment of the small
investor--new or higher fees for low balances, new or higher custodial charges, and a
2,400% increase in American Century's IRA opening minimum.

The most egregious personal harassment was from a teleclerk who refused,
because my IRA was too small, to correct computer errors in my account.  He added
that someone as insignificant as I was better off in bank CDs, and quoted
ex-Vanguard's John Bogle on small investors' threat to profits.  Second in
egregiousness were two other mutual-fund teleclerks who warned me against frequent
trading in funds I was selling the second time that calendar year, the shares
being ones I'd held for many years.

Expect the big players and rule-setters to pervert the current uproar into
further attacks on the little guy.  Why?  Mutual funds will continue to see
small accounts, not kickback-paying hedge funds, as the bigger threat to mutual
funds' investment palaces and golden parachutes.  Small investors are the
perfect target--they own a lucrative chunk of the balance but as solitary
individuals don't have the wherewithal to compete for the mutual-fund versions of
Lincoln bedrooms, Gray Davis legislation, and Halliburton contracts.

Florida-Style Proxy Voting

Walter Hewlett's proxy fight at Hewlett-Packard showed us how companies buy
votes from institutional investors.  If mutual funds allow kickback-paying
hedges to move rapidly in and out of mutuals, you can bet that hedges will be in
mutuals when mutual-fund managers need votes.  When American Century lost a
proxy vote, the company changed the definition of victory--a majority of
shareholders became a majority of votes cast.

The Dog That Didn't Bark in Bangalore

Peter Scannell, the Putnam whistle-blower, seems to be implying that his
annual salary to answer the phone and enter trades on a computer hovered around
$100,000--at a time when other industries contracting for similar work are
paying wages appropriate to buying cooking oil in Bangalore.  At the other end of
Putnam's pyramid, the CEO pulled down $32,600,000 per year.  Now we know why
Scannell--an older, less clubable newcomer--was the first whistle-blower.

News stories buried both salaries without comment.  I'm not suggesting that
anyone move anything to Bangalore--I recently tried to collect an auto
settlement from a Bharat voice in Oklahoma--but I do mean to imply that mutual-fund
incomes are appropriate to major-league baseball or confidence games, not to
order entry or telephone banking.

Because a look at compensation is the best way to detect a scam or even to
rate a fund versus competitors, complete salary information should be in a
prospectus.

Management Fees

Invesco's corporate parent submerged the Invesco brand name soon after
wasting investors' fees on re-naming the Denver stadium.

Invesco and other fund families continued to charge 12b-1 fees after closing
funds to new investors.  Particularly insulting is when 12b-1 fees siphoned
from closed no-load funds go to brokerages and financial advisors.

As mutual-fund assets have increased yearly, so have annual management
fees--in total, and as a percentage of assets.  If economies of scale exist, they're
going to fund management, not to customers.  And let's not forget Richard
Grasso's long fingers.  Copycat cultures, minimal competition, and lazy proxy
voters leave the restoration of market forces in the mutual-fund industry to
conscientious regulators or whistle-blowers.  Thank you, Peter Scannell, Eliot
Spitzer, and William Galvin.

Real Changes

Mutual-fund investors should demand respect by voting en masse against every
consolidation, every liquidation, every merger, every confirmation of inside
directors, every transfer agent, every advisor and subadvisor, and every
manager--until the industry reduces management fees and enforces the existing rules
equally for all customers.  Vote against any fund proxy that doesn't itemize
compensation, from executives to teleclerks.  We the poor could also vote
against further increases in small-account fees and minimums, but for some reason
small-account fees and minimums never appear in a proxy.

Now is the perfect time to try a nonprofit or credit union approach to mutual
funds.  As soon as I sort out the bad brokerages (25% of the largest
facilitated late trading by insiders), I'll be looking at exchange-traded funds (ETFs).

In the meantime, require that candidates for mutual-fund boards of directors
campaign for their seats.  Ask Jimmy Carter or the EU to oversee balloting.
The mutual-fund scandal is a mass-market version of two-tier morality.  Who
must post the huge bail--Bill Gates, Kenneth Lay, or the guy who ran onto a
major-league baseball field and tackled an umpire?  Who goes to jail--O. J.
Simpson or a black non-celebrity who's in the wrong place at the wrong time?  If
the amount you steal is large enough, the government offers settlement talks for
civil penalties and doesn't even require an admission of wrongdoing.  If your
hedge fund is too large to fail, Alan Greenspan will bail it out personally.
 
Begin these shenanigans on third base, finagle your way into the Air National
Guard until you can safely go AWOL, trade oil business favors for access to
your father, concoct Enron-like partnerships to hide your company's losses
until you can sell before the rush, escape an investigation by using your friends
at the SEC, take public money to build a stadium for your baseball team,
retain good hair into your fifties--and you can become president.

Let's get to work, ordinary investors and voters.

Author

Hunter Greer is currently compiling A Style Guide for Arguments and World
Political Checklists.  He may admit to developing a software program that trades
mutual funds according to the prospectus.  If he is, such a program has no
commercial potential.

Sources

Bush information is from Joe Conason's Big Lies via Paul Krugman NY Rev of
Books 20 Nov 2003, and from Molly Ivins' Bushwhacked.

History of management fees is from Bogle Financial Markets Research Center
and Lipper; via Christopher Oster and Tom Lauricella Wall Street Journal 5 Dec
2003.

Allegation of 25% of brokerages is from Kathleen Day Washington Post 4 Dec
2003.

Lasser at Putnam made $163 million in cash and stock, his last five years
before resignation, according to Gretchen Morgenson NY Times 7 Dec 2003.

Zitzewitz details are from Diana Henriques NY Times 16 Nov 2003 and Randall
Smith Wall Street Journal 9 Dec 2003.

Hillary Clinton's futures trading is from Spy magazine.