CAM refund is evidence of big losses

Your Funds

Your Money

October 31, 2004|By CHARLES JAFFE

SINCE THE mutual fund industry first got nailed for allowing improper trades, investors have been left with the nagging suspicion that someone really got hurt.

Managers and regulators said the harm was insignificant, a few pennies per thousands of dollars.

Settlements have included big fines, but minimal restitution.

But everyone suspected there had to be cases where rapid-fire trading led to much bigger performance woes. Simple mathematics suggested that the impact of improper trading had the potential to devastate a tiny fund.

The proof came recently, when Citigroup Asset Management, or CAM, filed an amendment to a prospectus to liquidate the Salomon Brothers International Equity fund, effective Dec. 3.

Salomon Brothers International Equity has about $5 million in assets and never got much bigger than about $10 million.

With miserable performance, it would have died unnoticed if not for an unusual item at the end of the closing notice.

"Citigroup Asset Management has decided that, following liquidation of the Fund, it will make certain voluntary payments to Fund shareholders to address CAM's dissatisfaction with the performance and operation of the Fund due, in part, to large cash flows that caused periods during which large cash positions were maintained in the Fund as a result of which the Fund's assets were underinvested in international securities."

In plain English, that amounts to: "We allowed market-timing trades like crazy in this fund, which made performance so bad that we need to give investors their money back."

Citigroup Inc. - which has been in hot water with regulators over other issues - currently is not facing charges or regulatory actions involving Salomon Brothers International Equity, so it's hard to see what compelled this action.

CAM issued only a terse statement saying it will "make certain additional voluntary payments to shareholders" without providing reasons for the action.

Up to now, the company has stayed out of the biggest improper trading scandals. Citigroup Global Investment Management did return $16 million to CAM mutual funds in a case stemming from alleged issues over back-room operations, but the International Equity payment is not part of that money.

Moreover, it appears CAM is prepared to make something close to complete restitution, repaying much of the difference between the fund and its benchmark index. According to Morningstar Inc., Salomon Brothers International Equity has the worst performance in the foreign large-cap blend category and has lagged behind the benchmark MSCI EAFE Index by 14 percent over the past three years, so payback would be a big deal.

The performance lag appears to be the cost of allowing improper trades in a small fund.

"This seems to be proof that investors endured significant harm from what fund companies were doing," says Mercer Bullard, founder of Fund Democracy, a shareholder advocates organization. "It was clear that there had to be a fund - most likely a very small one - where investors lost 5 [percent] to 10 percent per year over a three-year period. ... And it looks like this is the kind of small international fund that was mispriced to where it caused those losses for long-term shareholders."

CAM has not revealed the formula or rules involved in its voluntary repayments.

Like many funds targeted by regulators, Salomon International Equity apparently was dogged by "international fund arbitrage," which takes advantage of funds that set share prices based on the closing price of stocks in the home market (so a French company is valued when the market there closes).

That foreign market could close up to 10 hours before the U.S. market, yet international funds keep taking investments through the end of the U.S. trading day, creating a window for chicanery.

Someone gaming the system watches the domestic market, knowing foreign markets will move in sync, and then buys into (or sells out of) an international fund late in a big trading day. They get a stale price that is too cheap or too expensive, based on what the domestic market portends for the next day, and they profit on the discrepancy while passing most of the costs onto long-term shareholders.

The Salomon fund was so tiny that the big flows forced cash to the sidelines to meet quick redemptions; that, plus the impact of short-term trading costs, left long-term holders cut and bloodied. The impact might have been hidden in a $500 million fund, but not a $5 million one.

CAM may never face charges in this case, but the pre-emptive move clearly seems designed to keep regulators at bay, or to minimize future headlines and civil lawsuits (the fund was included in several class action cases).

"You have to wonder about the precedent," says industry consultant Geoff Bobroff of East Greenwich, R.I. "You don't volunteer to do this on a fund where everything is fine, or where you aren't looking at charges. Obviously, management here recognized that what it allowed to happen in the fund created a real problem for shareholders."

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