One of
the great successes of finance capital in the last decade – and
finance in American capitalism in particular – has been its ability
to draw more and more people, including workers, into its net. Across
the developed post-industrial world, ordinary people now have a stake
in how the financial markets are doing, simply because their personal
savings for the future is invested directly or indirectly in these markets.
This has come about through a combination of two processes. First, there
is the demographic factor, resulting from a change in the structure of
the population, with a greater proportion of the aged because of higher
life expectancy, and with a bulge of the post-war baby boomers now in
their prime, who need to save for their old age. Second, there is the
fact that in many countries, governments have progressively reduced their
own pension and other commitments per capita, and forced more people to
provide their own personal savings for the future. Just as is happening
in India today, fiscal incentives for personal savings were continuously
pushed away from bank deposits towards more risky capital market instruments.
But capital markets – in securities and the like – are notoriously
difficult for individual investors, and almost impossible for small investors
to negotiate successfully to ensure safe and secure returns for the future.
One response to this problem, has been the development of mutual funds.
A mutual fund pools together the individual holdings of small personal
investors, and works with the total sum. A mutual fund firm invests in
a broad range of stocks or other securities on behalf of a large number
of individual clients. These small investors mostly purchase mutual fund
shares through retirement plans or other savings plans for the future.
It therefore allows small investors to diversify holdings (and thereby
decrease risk) by creating a vehicle for a small amount of capital to
be invested in a large number of different securities.
In the heyday of the stock market boom in the 1990s, these instruments
were crucial in bringing many more small investors into the stock market
especially in the US. Today, it is estimated that the number of people
investing in mutual funds in the United States is nearly 100 million,
which includes around half of all households.
By now, US mutual funds alone manage as much as $7 trillion in assets,
which is why these funds have become such important players in emerging
markets across the world. Even a tiny shift in the portfolio, of say around
1 per cent, can cause huge movements of capital which can be deeply destabilising
for any particular emerging market. At the same time, the rapid increase
of these funds over the past decade has provided a large and growing source
of profit for fund owners, managers, banks and brokerage houses.
Of course, mutual funds are not limited to small investors; even larger
or more "elite" investors can invest in mutual funds. Indeed,
many larger investors often prefer these as slightly safer vehicles than,
say, hedge funds, which deal in large amounts of capital and are restricted
to large individual investors. It is the possibility of making a difference
between the millions of small investors who invest in mutual funds, and
the larger more powerful or more knowledgeable investors, which is at
the heart of the latest big financial scam in the US.
In the past month, the US Securities and Exchange Commission (SEC) and
state regulators in New York and Massachusetts have brought charges against
several large and influential mutual funds and their managers. The companies
include the mutual fund giant Putnam Investments, the brokerage firm Prudential
Securities, Alliance Capital Management, and a series of smaller mutual
fund companies. Individual brokers and executives at some of these firms
are facing criminal charges, while the mutual funds themselves face civil
fraud charges.
Just as happened with Enron and the series of corporate scandals which
broke out in America two years ago, the matter is now snowballing as more
and more firms get implicated. What began as an enquiry against a single
hedge fund by the New York regulator Eliot Spitzer (who was also instrumental
in prosecuting Arthur Anderson accounting company during the Enron scandal)
has now engulfed almost the entire mutual fund business.
The basic accusations concern "market timing" and illegal late
trading of mutual fund shares, both of which benefit an elite group of
investors and fund managers at the expense of millions of small investors.
Both of these are manipulations made possible by the peculiar way in which
mutual funds are priced.
Unlike many other stock market-based financial instruments, mutual funds
are not priced continuously on the market. Instead, at the end of each
trading day (4 p.m. Eastern Standard Time), the total value of the fund’s
investments is calculated and this figure is divided by the number of
outstanding fund shares, yielding the price per share. An order to buy
or sell a share in a mutual fund is held until the end of the day, when
it is processed at the closing price. The purpose of this is to prevent
investors from taking advantage of the very temporary movements in price
over the day.
However, this has created the possibility of "market-timing",
a process by which an investor takes advantage of the fact that the price
of a mutual fund is determined by the closing value of the shares owned
by the fund, regardless of when this closing value was actually determined.
Thus, for example, international stocks and shares owned by the fund are
priced at the value of the stock at the time of the closing of the market
in which they are traded, which can be hours before the closing of the
US markets. This is true of all Asian and European stocks, for example.
Since there are such large time differences involved and markets close
at very different times across the world, there could be events or information
which comes through to reveal to investors that actual value of the international
shares is different from the closing (or "stale") value. Therefore,
the real value of the mutual fund may be quite different from the calculated
value at the close of the trading day. This provides a tremendous opportunity
for profit, especially for insiders of fund managers, who can take advantage
of information that is not available to ordinary retail investors.
The other practice that has been used to deprive small investors of returns
at the cost of a favoured group of insiders of elite investors is known
as late trading. In this case, managers can benefit particular selected
clients by processing orders as if they were placed before the close of
the trading day, instead of later. This is because orders usually take
several hours to process, so that trades are usually allowed to go through
to the mutual fund well after closing, as long as the original order was
placed before the close of the trading day. So brokers can simply declare
that a particular order was placed earlier.
This practice is more than a bending of the law, it is strictly illegal,
although extremely difficult to monitor and regulate. But both of these
practices do more than provide windfall profits for a small group of favoured
investors or even insider managers themselves. They also affect the total
value of the mutual fund and therefore the return to small investors.
Whenever an investor sells at a price above the true market value of the
fund’s shares or buys at a price below the market value, the difference
must be absorbed by the mutual fund itself. This means that the total
value of the assets owned by the fund, and therefore the value of each
individual holding, must go down.
It is now clear that these practices were not restricted to a few unscrupulous
mutual fund managers, but were actually widespread across the hedge fund
and mutual fund industries. Every week since September, when the first
accusations against a hedge fund were made by Eliot Spitzer, new firms
have come up for scrutiny and been found wanting. Clearly, therefore,
millions of small investors in the US who invested in mutual funds have
lost some savings by virtue of these sharp practices.
The SEC has already been criticised for its inactivity and ignoring of
such fraudulent practices, which raise many parallels with the earlier
Wall Street scams. A recent settlement of SEC with Putnam, the fifth biggest
US fund manager, has been denounced by Spitzer and other regulators, for
not going far enough. Without admitting wrongdoing, Putnam has agreed
to "governance reforms" and to pay restitution to investors
who lost money as a result of its employees' improper trading. This is
tantamount to administering only a light slap on the wrist for very serious
financial crimes.
While some individual managers are being punished by losing their jobs,
the extent of punishment is not likely to be a deterrent to such activity
by others in the future. This is especially true when even those who are
forced to leave still make windfall gains in the process. For example,
the CEO of Putnam, Lawrence Lasser, is due to receive $89 million in parting
pay. He was already one of the highest paid executives in the industry,
receiving over $100 million in pay and bonuses over the past five years.
All this reinforces the arguments that are now well known, that financial
markets are prone to all sorts of imperfections resulting from incomplete
and asymmetric information in particular, and that these can give rise
to very serious malfunctioning and wrongdoing. It is also increasingly
clear that adequately regulating undesirable practices is difficult if
not impossible, given the ability of the markets to develop new forms
of malpractice, and the close social and political nexus that tends to
exist between financiers and those who are meant to monitor them.