Mutuals appear to be cleaning up their act

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September 11, 2005|By CHARLES JAFFE

THE MUTUAL FUND industry wasn't exactly celebrating the two-year anniversary of the largest scandal in its history last week.

But it is breathing a whole lot easier because the worst is over, in two distinctly different ways.

For starters, the behavior that dragged nearly 20 fund companies into the mud - allowing some shareholders the right to make rapid trades that were not permitted for all investors - appears to have stopped.

Second, a whole bunch of perpetrators seem likely to get off scot-free.

Research from Lipper Inc. makes it easy to draw both conclusions, although the second one is helped out by the actions of regulators, who appear to have moved on.

To see why, let's delve into the numbers.

It has been possible to track the data used in these studies for about a decade, but no one looked at the numbers because they were unaware the problem existed. Once the rapid-trading charges surfaced, industry watchers recognized that it wasn't hard to find the bad guys if you simply looked at two key numbers.

The first was "redemptions as a percentage of assets at the beginning of the year."

If the average fund shareholder keeps a fund for just under three years, the generally accepted figure, redemptions should run about one-third of assets in any given year.

So when redemptions are more than 200 percent of assets at the start of the year, a whole lot of selling is going on.

The second key statistic is "redemptions as a percentage of sales."

If an investor sells a fund and then buys it back, all of the money is flowing in a circle and long-term holders are paying the transaction costs. In most funds with long-term owners, redemptions would be a small percentage of sales.

Stephen M. Cutler, the former director of enforcement for the Securities and Exchange Commission, noted that if the first number - redemptions compared with assets - was more than 200 percent, and the second number was around 100 percent, you had a candidate for having allowed timing trades.

Cutler also testified before Congress that about half of the 80-plus management firms his office looked into were showing signs of trouble. Less than half of the firms he put in that danger zone have faced charges to date.

Here's where Lipper data tracking those key ratios gets interesting.

Based on data available just before the Sept. 3, 2003, date when the first shots of the scandal were fired - and looking only in the asset classes such as international funds where rapid trading was most likely to produce an advantage that a timer would trade on - Lipper found about 280 funds that fell on the wrong side of Cutler's cut-off, having allowed far too much trading for the investment pattern to be normal.

Of that group, about 60 funds were built to be market-timing vehicles, designed by firms like Rydex and ProFunds to accommodate rapid-trading strategies.

That still leaves more than 200 funds in the bubble.

And while the list includes plenty of firms that regulators took to the sin bin - AIM, Alger, AllianceBernstein, Columbia, Janus, MFS, Nations and Scudder to name a few - it also contains some big names that have avoided charges.

There are funds from Merrill Lynch, Morgan Stanley, J.P. Morgan and American Century, to name a very few, that all had redemptions amounting to at least 400 percent of assets, and where virtually all the money flowing out came right back in.

There are plenty of legitimate reasons why a firm might have funds that show up on the list, but if everything was on the up-and-up before the scandal started, then you wouldn't expect the behavior to have virtually stopped since the problem was first revealed.

Using the most current data available, Lipper did the exact same check again, post-scandal. Just under 110 funds fit the rapid-trading profile, and all but a dozen of those were timing vehicles.

Ordinary funds have left the danger zone.

"Since Spitzer turned the light on, this kind of activity has virtually stopped," says Don Cassidy, senior research analyst at Lipper.

Eliot Spitzer is New York state's attorney general and aggressive punisher of corporate wrongdoing.

"But there are a lot of funds that have the same profile as the ones that were named in charges, where it looks like nothing is happening, like the company is going to be able to walk away without facing charges, " Cassidy said.

SEC officials and state regulators insist they are still looking at these situations, but empirical evidence suggests that they have moved on, figuring the worst offenders have been caught, the penalties were minimal, the bad actions have stopped and there are bigger cases to pursue.

Says Cassidy: "Maybe at this point it's enough to know that funds aren't doing this stuff any more. I'm not sure investors will be totally satisfied with that but, right now, that looks like how it's all going to end up."

Charles Jaffe is senior columnist for MarketWatch. He can be reached at or at Box 70, Cohasset, MA 02025-0070.

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