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Did This Hedge Fund Pick Your Pockets?
New York Attorney General Eliot Spitzer says several of the nation's largest fund families allowed one hedge fund's late trading to steal millions of dollars from buy-and-hold investors.
By Steven Goldberg, Contributing Columnist, Kiplinger.com
September 3, 2003
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Investors may never look at mutual funds quite the same way after Wednesday's charges by New York Attorney General Eliot Spitzer.
Spitzer charged that a hedge fund engaged in illegal hanky panky with four of the nation's largest fund companies and cost investors hundreds of millions of dollars over four years. That's right, the money came right out of fund shareholders pockets, Spitzer says.
Janus and Strong, two of the largest no-load companies, were among those that entered into deals with Canary Capital Partners LLC, a hedge fund run by Edward Stern. Bank of America, which runs the Nation's funds, and Bank One, which runs the One Group of funds, also were named.
What's more, other fund companies may be involved and the total tab may be in the billions of dollars, Spitzer says.
Spitzer announced that Canary, two related entities and Stern had agreed to pay back $30 million in illegal profits and a $10 million fine. Plus, he said, Stern has agreed to cooperate in the probe, which is ongoing. "The full extent of this complicated fraud is not yet known," Spitzer said.
The fund companies say they did nothing wrong -- and all say they are cooperating fully with the investigation.
In a letter for fund shareholders, Janus President Mark Whiston, said, "We're reviewing the complaint closely and intend to continue cooperating" with Spitzer. Whiston added: "Like many other reputable mutual fund families, Janus is concerned about market timing in our industry. To that end, we're reviewing instances where frequent trading may have occurred to ensure that we continue to put the best interests of our fund shareholders first."
"We are fully cooperating with the New York State Attorney General's Office on this matter," said Drew Wineland, a spokesman for Strong.
Details of the probe to date are made painfully clear in a filing made public on Spitzer's Web site.
No-lose trades
Spitzer says the funds allowed Canary to make rapid-fire, short-term trades in many mutual funds. This was the same type of short-term trading forbidden to ordinary investors, and publicly discouraged by almost all fund companies. Indeed, fund companies generally go to a lot of work to ferret out short-term traders and boot them out of funds.
The funds allegedly told Canary exactly what stocks they owned on a daily basis -- information that individual investors and fund trackers like Morningstar have long been denied.
It is believed that Canary would then buy the fund and simultaneously sell short a basket of stocks that mirrored the fund's holdings. Selling short is a way of betting that the stocks will decline. When companies released earnings reports after the market's close -- reports that would move their stock prices the next morning -- Canary would be able to lock in trading profits by selling the fund or closing out its short positions.
"In essence," Spitzer's complaint says, "the late trader is being allowed into the fund after it is closed for the day to participate in a profit that would otherwise have gone completely to the fund's buy-and-hold investors."
Why did the funds permit Canary to do this? Mostly, Spitzer says, because they received large deposits in money market and bond funds from Canary.
Spitzer's complaint says, "Canary found many mutual funds willing to take that deal. In the period from 2000 to 2003, Canary entered into agreements with dozens of mutual fund families allowing it to time with many different mutual funds."
Presumably some of these funds are yet to be identified. But Spitzer specifically identifies several Strong and Janus funds. One, Janus Mercury, would be ideal for such a short-term trading strategy because it holds concentrated positions in just a couple of dozen stocks. So would another, Strong Growth 20.
Furthermore, Spitzer said Canary and Stern entered into deals with Bank of America and Security Trust Company that allowed them to trade hundreds of funds for hours after the market had closed.
This kind of late trading, as Spitzer said, is like "betting on yesterday's horse races."
This trading occurred, Spitzer says, largely through omnibus accounts, so that often the funds being victimized never knew what was happening. But it also took place through Bank of America's Nations Funds. These charges, against the Bank of America unit are by far the most serious Spitzer makes.
Handsome profits
While few long-term investors were making money during the 2000 to 2003 bear market, Canary's investors profited handsomely. After fees, the hedge fund returned 49.5% in 2000, 28.5% in 2001 and 15% in 2002. The hedge fund declined 1.5% in the first five months of this year and shut down. In a letter to investors closing the fund, Stern wrote, "We hope that you considered the ride to be a good one."
He says Canary had received about $40 million in management and incentive fees as of July 2003. So the repayment and fine he announced doesn't cover profits made by hedge fund investors -- or the equivalent losses of individual investors in the mutual funds.
The $30 million repayment that Canary was ordered to make will go into a restitution fund to repay fund investors harmed by the scheme. However, it's still too early to tell who will be able to claim the money or how much they'll get.
Spitzer, of course, played a big role in uncovering the conflicts of interests among brokerage analysts.
Through the recent scandals that rocked the nation's brokerages and investment banks and corporate chieftains, from companies both large and small, the mutual fund industry had remained largely untarnished.
Not anymore.