The Wall Street Journal reported last month that the House of Representatives passed a “Mutual-Fund Corruption Bill” that will supposedly “curb mutual-fund trading abuses.”
The bill passed overwhelmingly, and follows over three months of hysterical comments from Eliot Spitzer and others eager to be on the supposed right side of the scandal. Recently Spitzer has described the industry as a “cesspool,” and evidently now a pricing expert has informed USA Today that he doesn’t “believe funds have negotiated aggressively to keep fees down.”
Not wanting to be left out, or worse, overshadowed, SEC Chairman William Donaldson has told USA Today that the scandals are “damning,” and has promised to “punish the perpetrators” for any wrongdoing.
All this might be interesting to a lawyer lacking a political agenda, in that early on Spitzer admitted to the Wall Street Journal that neither “timing trades” nor “late trading” is illegal.
Law or no law, the question that needs asking is whether these scandals merit regulatory intrusion, and if so, what will be the consequences?
To begin with, Spitzer and others have made it clear that they would like these dubious trading techniques to end, since they advantage the large investor at the expense of the small one. This is, presumably, fair enough. The Wall Street Journal’s Jonathan Clements said in his November 5 column — appropriately titled “How to Pick a Mutual Fund That Cares About Its Long-Term Shareholders” — that excessive timing-trades force funds to maintain excess cash that “can act as a drag on returns.”
His words bear special scrutiny. When I was in the brokerage business, one of the first things potential customers asked about was the proposed money managers’ records. My experiences are hardly unique in this regard: Investors are obviously interested in getting a high return on their money, and past returns are one way of gauging the quality of the manager.
Funds are able to attract investors, and earn fees on investor funds, if their performances have been good. One need only buy the next Barron’s, Fortune, or Forbes to confirm this. The November 10 Barron’s features full-page advertisements from money managers American Century and Lord Abbett. Unsurprisingly, both ads cited past returns.
This reality should give lawmakers and regulators pause as they seek scalps in this latest “scandal.” Impressive returns are once again what attract customers, and to the extent that mutual fund companies allow excessive trading in their funds, they only imperil their own returns.
This logic isn’t lost on Clements. Although perhaps not intentionally, his column stated the obvious: “What they (mutual fund companies) really care about is their own bottom line.” They sure do, and one thing that’s been very clear as the scandals have unfolded is that timing and late traders were a source of fees for mutual fund firms.
Clements acknowledged this, too, pointing out that when “timers pile into their funds, the fund companies involved make more money, because they can now charge money-management fees on a larger pool of assets.” But if the mutual fund industry is indeed a “cesspool,” and a “morass of conflicts of interests,” as Eliot Spitzer has told the New York Post, how is it that returns have been so good over the years?
In his November 2 column in the Washington Times, “Hold on to that mutual fund,” Cato Institute senior fellow Alan Reynolds seems to have found the answer. He cited Lipper’s list of the 125 largest and most popular stock funds, and noted that 123 yielded an average total return of more than 30 percent over the past five years. The answer seems to be that while some funds accept market timers and the fees they offer, they’re also smart enough to balance the interests of timers and ordinary shareholders in favor of the latter so that their returns aren’t harmed, and their capital doesn’t flee.
Note though how Reynolds cited the returns of the largest, most popular stock funds. This matters, because he went on to write, ” … only two of the several mutual fund companies under regulatory scrutiny have many funds among the largest … ” The latter figure raises the question of whether it is fair to assume that the majority of funds that allowed timers were in their nascent stage, and so were most in need of the large cash infusions that market timers would provide. Having made that assumption, is it also fair to assume that once established, funds are more likely to jettison the dollars of market timers that were only needed in their growing phases?
All of this is important because Spitzer is on record as having somehow divined price gouging in the $7 trillion mutual fund industry. If market-timing hedge funds have in fact played a “seed” capital role among mutual funds, and have helped those funds’ bottom lines, what will be the result of the presumed new regulatory environment? Doesn’t logic suggest that the mutual fund industry of the future will be smaller and characterized by less competition?
Indeed, what regulators and lawmakers never seem to understand is that businesses are for profit, and will either charge what it takes to stay in business, or fold. The absence of fees that resulted from market timing suggests that there will be some unforeseen and negative consequences that come from Spitzer’s latest crusade, probably along the lines of higher loads to recoup the aforementioned lost fees, less in the way of mutual fund choice, and — as a result of that lack of choice — less in the way of price competition.
Just as when he helped scotch the IPO market, the results of Eliot Spitzer’s latest efforts will likely not be known for some time. And by the time those results are known, Eliot Spitzer will have found yet another “voter friendly” issue to exploit, and will have left it to the productive in society to once again clean up his mess.
–John Tamny resides in Washington, D.C., and spent four years in the brokerage business. He can be contacted at jtamny@yahoo.com.