Mutual fund scandals
Is U.S. experience mirrored in Canada?

Last week, it was announced that New York Attorney General Elliot Spitzer has the mutual fund industry and an alleged scandal involving a hedge fund in his sights. Spitzer is the same man who spearheaded the billion dollar lawsuits against the world's largest brokerage firms and their then star technology stock analysts for publishing biased stock recommendations. If true, this has many wondering how many other scandals have yet to be uncovered - and if this could be happening here in Canada.

The U.S. scandal

Spitzer alleges that some of the United States' largest fund companies - namely Banc One, Janus, Strong Financial, and Bank of American Nations Funds - allowed a New Jersey based hedge fund, Canary Capital Partners, to enter into illegal short term trades, thereby harming other unitholders remaining in the funds.

Since overseas markets close before ours does (they are at least several hours ahead of us), unit prices on overseas funds sold in North America reflect market activity from the previous trading session. Since the current day's trading is already done, opportunistic investors could place trades today based on market activity they know has already occurred.

This case alleges that Canary used this time delay and placed large trades after hours (i.e. after the unit prices had already been confirmed) to generate what was, in essence, a risk-free profit - i.e. time arbitrage. The result: remaining unitholders were hurt because Canary was supposedly allowed preferential treatment to buy low and sell high.

Domestic experience

There is no shortage of scandals in the Canadian investment industry. Hollywood-like stories of Bre-X and Cartaway Resources aside, scandals involving RT Capital, Transamerica Life and Strategic Value Corp were all unveiled during what proved to be a very busy year 2000.

A handful of portfolio managers at money manager RT Capital were found guilty of manipulating stock prices to artificially boost investment performance. Since RT was one of the larger pension fund managers in the country, this impacted a large number of Canadians.

Some Transamerica Life employees were also involved in a 'time arbitrage' scandal. In this case, the company was not accused of encouraging or condoning the activity, but employees were deemed to have breached their duties to their employer and the firm's clients.

Strategic Value Corp's founder Mark Bonham was found to have manually changed prices on a number of stocks held by some of the firms funds, resulting in inflated fund performance. This was discovered shortly after the firm was acquired by NovaBancorp. Nova was later acquired by the Caisse de depot et placement du Quebec - which sold the troubled fund company to Dynamic Wealth Management last summer.

It has been subtly publicized that Canadian fund companies deal with a number of institutional traders. A quick glance at a press release from CI Funds shows that institutional traders (some or all of which may in fact be hedge fund managers) are active among Canadian mutual funds. And they're not likely the only firm to have attracted such traders.

I am not aware of any Canadian firm participating in the types of activities in which the handful of U.S. fund companies have been alleged to have participated. While the potential exists because such traders are active in Canadian funds, I'm encouraged by the fact that many fund companies, like CI, have asked some traders to leave - and take their trading money with them.

Solutions

Some firms practice what's known as fair pricing, which involves estimating, for instance how a European fund will react based on U.S. market activity. However, anytime the industry must engage in guessing unit prices, some investors are inevitably hurt.

A more straightforward approach is to charge a flat percentage fee for short term trades. In fact, most fund companies have had this written into their prospectuses for years. In practice, however, most load companies simply don't exercise their right to charge this fee until such time as the trading becomes too frequent and involves large dollar amounts. No load fund companies, on the other hand, tend to go by the book on this policy.

In both cases the maximum short term trading fee is 2 percent of the trade value. Given the volatility in today's markets - particularly with many narrow mandate funds - I think the fee should be raised.

One possibility is to simply raise it across the board, to something like 5 percent - at least on equity, specialty, and balanced funds. Another option is to scale the fee based on the amount of dollars (or percentage of fund assets) involved, since trading by small investors will do no harm to remaining unitholders. Fund companies cannot be blamed for accepting an investor's money. However, they have a duty to protect their unitholders' interests so either more strictly enforcing the existing fees or implementing one of my suggestions should do the trick to discourage such harmful activities.