Ugly Turn in Fund Scandal

Editor's note: This column has been updated to correct an earlier error.

I guess we shouldn't have been surprised. In fact, I know we weren't surprised that the mutual fund scandal would expand, because we said as much last month. Once mutual fund managers have made the decision to allow others to market time in their funds, it was but a small step for the fund managers to do it themselves. In an interview with CNBC, the Securities and Exchange Commission Enforcement Director Stephen Cutler said that they had found evidence of just this very thing -- of executives and managers timing their own funds.

One fund company, Putnam Investments, a subsidiary of insurance giant Marsh & McLennan (NYSE: MMC  ) , announced yesterday it had fired six fund managers, some for market timing using their own money in accounts they managed. You can add Federated Investors (NYSE: FII  ) to the list of companies allowing big money clients to trade in ways their individual customers cannot, but Putnam -- and whomever else Cutler has on his radar screen -- have taken fleecing their fund clients one step further.

What a total, complete disgrace. With this revelation, the mutual fund scandal has taken a step from being a crisis to being an absolute abomination. Where before we had the equivalent of a bank manager "accidentally" leaving the safe door unlocked, now the bank manager's loading up his own bag with your loot.

Here's my word on Putnam: If you hold one of their funds, get out. Run away. Putnam fired these managers yesterday even though they caught them making these trades in 2000. Putnam left a group of thieves in charge of billions of dollars of other peoples' money, and seems to have finally made the move to fire them only once the SEC and the New York Attorney General's office took interest. What bigger message could a company give that it doesn't give a damn about its clients? "Yeah, they stole from you. We gave 'em a 'do over.'"

There are two major ways that individual investors in funds are being taken advantage of. In the case of Putnam, the managers are accused of market timing. Market timing is a way of arbitraging the value of a fund since the price that it can be bought at is only set once a day. Mutual funds do not trade or fluctuate in price during the day -- all of the trades in and out of a fund are done at a fixed share price at the end of the trading day. The manager takes the total amount of assets in the fund (the Net Asset Value), and divides by the number of shares. So, the way it's supposed to work is that any trades submitted by clients after the trading day ends have to be executed at the next day's price. But particularly with international funds, with many companies trading in overseas markets, you can see what's going on in the markets while the funds, locked down here in the US, do not change in value. The expectation being that there is a correlation between the two. Except funds aren't made for rapid trading, and generally expressly forbid it.

This process costs all of the other shareholders, because the fund, if you recall, is shares divided by assets. You've just taken assets out of the total fund pool that you did not earn. A penny here, a penny there, and soon you're talking... well, according to an academic report cited in The Wall Street Journal, you're talking $5 billion dollars. And who better to know what the largest holdings in a fund are at any given moment than the fund's own manager?

So, folks with money at Putnam (and other funds which are sure to be disclosed in the next few days), those fund managers have been stealing from you. What they did was no different than swiping your credit card. It wasn't even particularly sophisticated. It was theft. We here at the Fool have long been of the opinion that the majority of fund managers do their clients a disservice by over-charging them for underperforming the market, but to a person, I doubt very strongly that any of us would have predicted this.

Three years, and Putnam didn't fire these guys. What an absolute disgrace. They may not feel shame in Putnam's offices today because it seems to me that in the business world, shame is one thing that comes in short supply. But I hope they feel the pain of billions of dollars of fund redemptions, because this company deserves to be entrusted with not a nickel of other peoples' money.


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