A Benign Disaster?

Quick: Guess how much money investors in Putnam Investments mutual funds were cheated out of in the market-timing scandals. Hint: It wasn't the $110 million Putnam agreed to pay the SEC and Massachusetts's regulators. An academic, hired by Putnam to calculate losses attributable to market-timing and excessive trading, reckons the number is more like $4.4 million. And that includes interest.

The $4.4 million sum — calculated over several months by Harvard Business School professor Peter Tufano — is a substantial sum, but for a company that had more than $250 billion in assets at the time of the misdeeds, the losses seem, well, somewhat underwhelming. That said, Tufano reckons that the actual, total losses were probably far higher — perhaps $48.5 million, including interest — if you factor in the panic selling the news of the market-timing and excessive trading caused.

This is not to apologize for the misdeeds of the several Putnam employees involved, but let's face it: Most shareholders will eventually receive less than $1 in compensation, and many will get nothing, says John Hill, chairman of the Putnam Investment Management Board of Trustees. Worse, there may be no way to accurately figure it out. The SEC, in accepting Tufano's report in March, agreed that his “methodology is acceptable” but stopped short of full endorsement, saying there may be other ways to calculate losses to fund shareholders.

And that's precisely the problem. Putnam is the first company to provide an estimate of the impact of its employees' shenanigans, and its experience is likely to prove typical. In an era when the Enron and WorldCom sagas have produced dramatic trials and enormous losses, the fund scandal has caused investors far less damage. (Indeed, investors continue to pour record amounts of money into funds.) Dozens of executives at fund companies lost their jobs. Fund families such as AIM and Janus suffered redemptions and scarred reputations. Still, the scandals seem to have produced relatively little impact, considering the many months of headlines and the $3 billion in total fines and penalties imposed by regulators.

Of course, this could be the calm before the storm. Former Bank of America broker Theodore Shiphol faces 40 counts of criminal and civil charges — for his role in illegal trading of mutual funds — in a trial scheduled to start in April. He is charged with stealing around $1 million from several mutual funds. And, while it has been difficult to quantify actual losses, fines will continue to be levied. This March, the NYSE fined Merrill Lynch $13.5 million because brokers had facilitated market-timing by a hedge fund.

For some perspective on the market-timing mess, compare the results of the fund scandal to an earlier tempest that was also started by New York Attorney General Eliot Spitzer: the investigation of Wall Street analysts. After Spitzer had finished handing out penalties, the entire profession of security analysis had been turned upside down. Wall Street firms slashed salaries, laid off herds of analysts and reorganized how research departments were compensated (see related story on page 57). In contrast, the mutual fund industry has emerged, so far, with relatively few changes. Most fund managers have kept their jobs — and their fat salaries. In 2004, $242 billion in new cash flowed into funds, one of the best years ever, according to Financial Research Corporation.

The Ill-Gotten Booty

To appreciate what has occurred in the fund industry, it is important to keep in perspective what happened — and what did not. First consider what has not happened. So far, shareholders have not received a penny in compensation. That may be disappointing for investors who have read about the Putnam settlement and vast sums in penalties collected by the SEC. Eventually, some shareholders may find small checks in the mail. Harvard Business' Tufano is still working out a plan for the distribution to Putnam investors, says the SEC, but the process of calculating compensation is proving elusive. Part of the problem is that this is a strange scandal: It is hard to figure out how much was lost and who lost it.

It also helps to understand that the fund investigations centered on the kind of rapid trading known as market-timing, which isn't necessarily illegal. In a typical deal, a market-timer might note that the American markets had risen 2 percent. A few minutes before the closing bell at 4 p.m., the speculator would buy shares in a fund holding Asian stocks. Because mutual funds are priced at the New York closing, the trader could benefit from what are called stale prices; since the Asian markets were closed for the night, prices had not yet reacted to the American news. The trader might pay $10 for shares that would be worth $10.20 when Asians woke up and bid up stock prices. If the fund could not invest the trader's deposit right away, the portfolio would be diluted with his cash and the gains of other shareholders would be reduced when stocks rose.

The problem is calculating the net losses to shareholders. In some cases, the speculator may have gotten it wrong, losing money on the trade and actually enriching fellow shareholders. “This is breaking new ground, and there is no rule book for answering the key questions,” says Barry Barbash, a former SEC official who is now a partner with law firm Shearman & Sterling in Washington, D.C. “It will take a lot of effort to figure who owned shares on which days and how much they lost. In the end, the amount of damage for many accounts will be in the pennies.”

Whatever the cost, Putnam, for example, says it will pay 100 percent of any “post-disclosure redemption costs” once, or, as the SEC put it, “if any should be attributed to Putnam's misconduct.” And that's not the only solution proving elusive: There have also been no new regulations aimed directly at stamping out market-timing. To stop speculation, the SEC proposed a so-called hard close to trading, requiring all investors to have completed their trades by 4 p.m. Eastern time. But devising a regulation is proving time-consuming. Companies have complained that policing the rule would require investments in new technology. So far, the SEC has yet to issue a final proposal.

Another SEC proposal called for mandatory redemption fees for the entire industry. Under the proposal, a trader who bought shares and then sold them within five days would have to pay 2 percent of his assets. That would take a bite out of market-timing profits. But winning support for the proposal proved more difficult than the regulators expected. Sponsors of 401(k) plans worried that their participants would be unfairly penalized.

Consider the fate of a conscientious saver who owns a fund that automatically reinvests dividends and rebalances the portfolio. On a Monday, the fund receives a dividend and uses the cash to buy more shares. Then on Friday it is time for the regular annual rebalancing. The fund sells some of the newly bought shares — and gets socked with a 2 percent penalty. Concerned that redemption fees would only cause pain to legitimate investors, the SEC watered down its proposal in an early March statement. Under the new version, funds may impose fees on a voluntary basis, something that they have been able to do for years anyway.

While rules aimed at stamping out the central problem have languished, other regulations have come into effect. Among the most controversial is a rule requiring that chairs of fund boards must be outsiders — not employees of the companies. Led by Fidelity Investments, the industry fought the rule. Fidelity and others produced studies showing that funds chaired by insiders had better ethical records and higher returns than companies headed by outsiders.

But the SEC was not impressed. According to the Investment Company Institute, the fund trade group, companies are marching to the new tune, lining up outsiders to take leadership roles. But it is not clear that the change will result in a cleaner industry. “The independent board members will not have any impact,” says Edward Siedle, president of Benchmark Financial Services, an investment consultant in Ocean Ridge, Fla. “In the past you could hire your best friend who worked for you. Now you can hire your best friend who never worked for you. There is no chance that an advocate like Ralph Nader will suddenly show up on the board of a major fund.”

Even if new regulations may have little impact, some things clearly are different in the fund industry. And just as it is important to note what has not changed, it is valuable to recognize that in some ways the financial world has been altered by the scandals. The reputation of some fund families remains tarnished among advisors. Cerruli Associates, a Boston-based consultant, recently surveyed financial advisors on their attitudes about funds. The respondents said over and over that they would only buy funds with unblemished ethical reputations; says Kirby Horan, a senior analyst at Cerulli: “Some advisors are still avoiding funds that ran into problems, including Putnam, Janus and AIM.”

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