When the market timing scandal first broke last year in the United States, even industry experts thought crusading New York State Attorney-General Eliot Spitzer had finally gone too far.
Then Mr. Spitzer started digging out e-mails that revealed some of the biggest U.S. mutual fund families, household names such as Putnam, Alliance Capital and Bank of America, secretly favoured short-term professional traders over the mom-and-pop investors who entrusted the money mangers with their savings. Suddenly, the U.S. industry had a first-class scandal on its hands.
Among those caught and punished by Mr. Spitzer was Toronto-based Sun Life Financial Inc. subsidiary Massachusetts Financial Services Co., or MFS, a $40-billion (U.S.) fund manager with a previously pristine reputation. Documents that explain the $350-million settlement paid to regulators by MFS provide a case study of just what played out in the shadows.
Main Street investors buying funds from MFS, one of the oldest American fund managers, could and did take comfort from a line in the company's prospectus that stated: "The MFS Funds do not permit market timing or other excessive trading practices that may disrupt portfolio management strategies and harm fund performance."
In fact, nothing could have been further from the truth. The U.S. investigation found evidence of rampant market timing by hedge fund investors who bought into 11 different MFS funds from 1999 through 2003. According to the settlement reached with regulators in February, documents provided to the fund company's most senior executives showed "known market timers at MFS held approximately $2-billion in assets as of May 31, 2003."
It got worse for MFS. According to the settlement, it not only knew about the market timers, it encouraged them to climb aboard, despite the obvious threat they posed to long-term investors. The settlement with Mr. Spitzer states: "MFS routinely provided certain dealers with its internal policy allowing market timing in the funds and routinely directed known market timers to the funds."
Why did MFS and the other fund families get in bed with the market timers? Mr. Spitzer's investigation revealed an I'll-scratch-your-back-if-you-scratch-mine relationship.
The fund families wanted more assets in offerings that featured lucrative fees. The pros wanted to make easy money by market timing. So a stockbroker with Kaplan & Co. Securities in Florida sent an e-mail to Nations Bank fund managers that resulted in the following internal e-mail, captured by Mr. Spitzer: "He would place a trade for xxx dollars (we tell him how much -- $5 to $10-million??) in one of our funds (long-term trade) -- possibly one of the LifeGoal funds. In return, we could let him market time the Nations Large Cap Index Fund ($5-$10-million, we set the amount.)"
What was in it for the hedge funds? Massive profits. Canary Management, a New Jersey hedge fund with more than $730-million of assets that traded with a number of fund families and has now been wound down, posted a 16.3-per-cent gain in 2002 and a 28.5-per-cent win in 2001, years when the benchmark S&P 500-stock index was down 14.9 and 13 per cent, respectively. Canary is controlled by New Jersey's Stern family, one of the wealthiest clans in America, and e-mails collected by regulators show fund companies were willing to bend the rules in order to win more of the family's business.
The only loser in this cozy relationship was the ordinary investor, who saw their holdings diminished by the short-term costs incurred to keep the market timers happy. And until Mr. Spitzer began his crusade, it seemed no one was looking out for the little guy's interests.
Andrew Willis