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Come See the Parasites

An investor I know put it quite simply. "Where the hell is the SEC on this?" Once again, it wasn't our federal watchdogs who took down a massive scam of the investing public, it was a state attorney general -- this time Eliot Spitzer of New York. Once again, he's gotten his teeth into a bunch of folks who have a fiduciary responsibility to protect the assets entrusted to them, and failed miserably to do so.

Thus far the scandal has put Bank of America (NYSE: BAC  ) , Janus (NYSE: JNS  ) , Strong, Bank One (NYSE: ONE  ) , J.B. Oxford (Nasdaq: JBOH  ) and other mutual fund managers in a very bad light. This is certainly just the tip of the iceberg.

Last time it was the Wall Street analysts and their tainted recommendations -- soiled by the filthy lucre of their investment banking clients. Before that it was corporate scams -- WorldCom, Enron, ImClone (Nasdaq: IMCL  ) , Tyco (NYSE: TYC  ) . Now, it's the mutual funds. And what these people have done is reprehensible to the core. This isn't investing. It's stealing, the kind that drains the lifeblood from our markets.

On Wednesday Spitzer dropped a complaint on Canary Capital Partners and its principal, Edward Stern, claiming that they had conspired with 30 different mutual fund companies to engage in two practices: "late trading," which is illegal; and "timing," which, while not illegal, must be disclosed in fund prospectuses. Which it wasn't. Canary agreed to cooperate with Spitzer's investigation, to disgorge $30 million in ill-gotten profits from the practices, and to pay $10 million in fines.

Betting once the cards are on the table
Here's how "late trading" works: Mutual funds can only be bought and sold at the market close at 4 p.m. Any orders received during the day are filled at the closing price, which for mutual funds is net asset value, or total net assets divided by number of shares. But companies often make big announcements after trading hours. So, for example, a fund that held a large number of IBM (NYSE: IBM  ) shares would necessarily be affected if IBM came out after hours and reported strong earnings.

Armed with the knowledge of what happened at 4:45, Canary was going back and buying shares at the 4 p.m. prices. It's sort of like being able to bet on a blackjack hand after the cards have been played. That's not investing; it's not even gambling. It's theft. Canary could take these shares, sell them the next day when the price adjusted to the news, and bank a profit. Every single time.

And each dollar Canary accumulated using this scheme came directly from the pockets of the long-term shareholders of the funds. After all, when Canary turns around and pulls out that few million in assets, it takes with it profits that should have gone to long-term holders.

It's four o'clock somewhere
"Timing" works a little differently and is based on the arbitrage between market hours in the U.S. and overseas, mainly. If PetroChina (NYSE: PTR  ) announces a big dividend increase, its shares trading in China react. But it's still nighttime in the U.S., so timers have the ability to jump into funds on one day, wait for the price to react to the news, and then get out. This can be quite expensive for funds, which are not generally set up to handle rapid trading. In fact, most funds have specific language prohibiting timing by clients.

But at least 30 different funds allowed Stern and Canary to do both of these things. Bank of America even installed a computer terminal on its own network in Canary's offices to make it easier for them to trade late. This is murder on the returns for the funds -- so why do the fund companies allow it? Because these arrangements are extremely lucrative for them, and their fund shareholders can't possibly feel the effect.

Remember, fund managers are employees of the management companies, not the funds themselves. The management company makes money on a percentage of assets, and the timers give them something of value -- a larger asset base. Further, some fund companies signed deals with Canary giving them the right to time in exchange for an agreement for Canary to park millions of dollars in other investment vehicles they also managed.

Of course, none of this was ever disclosed to the retail fund investors. In fact, several funds waived the early redemption penalties for Canary that were meant to dissuade rapid trading. Spitzer's complaint against Canary had example after example of fund-company executives discussing the problems associated with Canary's activities, and then justifying their participation based on the amount of money this client was earning for their corporations.

So Edward Stern took advantage of the ignorant to generate big returns for his clients. His big wallet convinced corporations that it would be worth their while to break the law to allow him to shoot a couple of fish in a barrel each day. Does the $40 million come close to repairing the damage done to individual shareholders? Not even remotely. But recognize what this particular complaint is -- one against the hedge fund manager. The other side of the equation, the mutual fund companies, can rest assured that their willingness to compromise their retail clients' trust will cost them plenty more -- the inevitable class action suits more so. It still won't be enough.

You think they just did this once?
I'd bet that we've only seen the first allegations. There is a tendency in business that somehow seems to be amplified on Wall Street: That which makes money is done to excess. There is very little chance that a Bank of America or a Janus looked at the arrangement it had with Canary and thought "Well, OK -- we'll do this just this once." There are thousands of hedge funds in existence, many of which are much larger than Canary Capital.

What are the odds that this wormhole goes deep, that there are dozens of companies engaging in similar activity with fund managers? The complaint against Canary lists dates from 1999 to 2003, but many fund companies had language in their prospectuses prohibiting timing long before that. Edward Stern may be a smart guy, but should we assume that he had a monopoly on the knowledge it takes to late trade? How about the financial strength to make it worth the fund manager's effort? Doubtful on both counts, which means that abuse by fund managers might just be epidemic.

Seeing as nearly half of all households are invested in mutual funds, it's a pretty scary prospect to consider that each of us may be losing money, drip by drip, to a bunch of parasites with the low-tech version of a Wayback Machine.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Stories like this make Bill Mann think putting money under the mattress is a good idea. By way of disclosure, he owns none of the companies mentioned in this article.

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