Funds' Dirty Little Secrets

The more time I spend in the money management industry, the more I learn about the nearly infinite number of ways that investment firms can take advantage of their investors. All sorts of abuses result from the combination of motive -- there's big money at stake -- and opportunity. Even sophisticated investors (of which there are few) aren't aware of or can't detect certain activities.

Every investor by now has heard about the billions of dollars stolen from investors because many of the largest money management firms allowed market-timing and late-trading activities. In last month's column, The Disgrace of Soft Dollars, I described how investment funds are secretly lining their pockets by inappropriately charging billions of dollars' worth of expenses to investors. Today, I'd like to share a few other dirty little secrets of the money management industry.

Painting the tape
Painting the tape is an old trick in which a fund or group of funds aggressively buy a stock near the end of a quarter or year to drive its price up, thereby improving their performance. It's hard to know how common this activity is, but I've seen enough cases to believe that it's widespread.

There are particularly strong incentives for hedge funds to do this at the end of a year, when performance incentives -- generally 20% of profits -- are calculated. Let me give you an example of how this might work. I own nearly 250,000 shares of one particular micro-cap stock that barely trades (which is one of the reasons why a debt-free, profitable, growing company trades at a substantial discount to its liquidation value). By putting in a market order for a few thousand shares at the end of a year, I could easily drive the stock price up $0.50. This would translate into an extra $125,000 of reported profit for my fund -- and my 20% share of this would be $25,000. You can see how tempting such activity is for unscrupulous managers.

While most investors can't do anything about this kind of nonsense (other than hire honest managers), I've heard of one creative solution to this problem. A large investor in a hedge fund negotiated a clause that said the fund's profits would be calculated based on each stock's average price over the last five trading days of the year and the first five trading days of the following year.

Valuing illiquid or untraded securities
An article in TheWall Street Journal last year reported that the Clinton Group, "one of the largest hedge-fund operators, has been accused by a recently departed employee of misstating the value of some bonds in its portfolio. Regulators are investigating." Whether the employee's accusations are true or not, this story highlights the fact that investment funds have immense discretion in valuing certain illiquid positions such as obscure bonds, micro-cap stocks, options, and private placements.

For example, I own a few long-term put and call options (discussed in two previouscolumns) that sometimes don't trade for many days, as well as warrants to purchase the stock of EVCI Career Colleges (Nasdaq: EVCI  ) , which don't trade at all. I value these securities very conservatively. For instance, if the last trade of an option was $13, but the bid-ask spread was $12.40-$12.60, I mark it down to $12.60. But you can see the potential for abuse.

Who pays the bill?
Certain expenses are charged to a fund, whereas others are paid for out of the management fee. However, determining which is which is not always clear. In general, direct expenses of the fund -- commissions, interest, the annual audit -- are paid for by the fund, and expenses of the manager -- office costs, staff, overhead -- are paid by the manager, out of the management fee.

This sounds simple, but in practice there's quite a bit of gray area -- which leads to the potential for abuse. What about travel costs when the investment manager visits a company? Or research services like FactSet Research Systems (NYSE: FDS  ) or Capital IQ (a great service that I subscribe to), which can cost tens of thousands of dollars per year? Or hiring a firm to interview customers, competitors, or former employees of a company as part of the due diligence on it? All of these expenses undoubtedly benefit the fund, but it's often not clear whether they should be paid for by the fund or the manager.

There's nothing wrong with charging a fund for expenses like these as long as they're disclosed. In fact, I know managers who charge every expense to their funds (generally in exchange for little or no management fee). Where I have a problem is when investors are being charged significant expenses that they're not aware of, which is often the case.

Stuffing
When an investor withdraws from a hedge fund, most partnership agreements allow the fund manager to "stuff" the withdrawing investor with excess realized taxable gains, which benefits the remaining investors without -- some claim -- harming the withdrawing investor. Based on this explanation and assurances that almost all hedge funds stuff withdrawing investors, I authorized my auditors to do so when preparing the 2003 K-1 tax forms for my investors.

But after seeing the completed K-1s, I realized how outrageously unfair stuffing is. While the total capital gains are unchanged, withdrawing investors are effectively saddled with a bigger tax bill because a higher proportion of the stuffed investor's taxable gains are paid at the short-term capital gains rates (rather than at the lower long-term rates), plus more taxes are due a year earlier than they otherwise would be. Upon realizing this, I told my auditors to re-do the K-1s without stuffing, but it's shocking to think that an estimated 90% of hedge funds are doing this to their departing investors. I wonder how many investors are even aware that this is being done to them?

Conclusion
When hiring a firm to perform any service, it always pays to ask the right questions, check references, and so forth, but it's especially important when it comes to trusting someone with your hard-earned savings. To protect yourself, I recommend the following steps.

For mutual funds, stick to companies that have long-standing, well-deserved reputations for integrity. These twoarticles by my colleague Zeke Ashton highlight some of the best funds.

It seems obvious that one should avoid firms that have been implicated in the market-timing and late-trading scandals, yet investors continue to invest in -- or at least not take their money away from -- such firms. There's a lot of truth to the saying "fool me once, shame on you; fool me twice, shame on me."

Be extra careful when investing in hedge funds. I run one and know many great hedge fund managers (I profiled a dozen in Buffettesque Superinvestors), but there is significantly more incentive and opportunity for mischief in lightly regulated hedge funds, so make sure you really know and trust the person managing the fund.

Looking for funds with excellent prospects and ethics? Check out Motley Fool Champion Funds.

Whitney Tilson is a longtime guest columnist for The Motley Fool. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. He owned shares of EVCI Career Colleges at press time, though, positions may change at any time. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.


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