Senate & House Investigate Late Trades, Post-Canar

WASHINGTON (HedgeWorld.com)–As panels in each of the houses of the U.S. Congress are looking into the market-timing, late-trading charges against hedge funds and others alleged in recent months to have abused the long-term investors in mutual funds, one crucial question to emerge is whether the interests of the directors of mutual fund management companies are in conflict with those of investors.

Eliot Spitzer, Attorney General of New York, began his prepared testimony to the House Financial Services Committee’s subcommittee on capital markets, Tuesday, by reminding the subcommittee that two months ago “my office announced its settlement with [Canary Capital Partners LLC]. Our investigation … revealed that some of the nation’s largest mutual fund companies permitted hedge funds to take advantage of after-market information by buying and selling mutual fund shares at the net asset value that had been set earlier that day when the markets closed.” Late trading is illegal. The related practice of market timing, although not illegal, is, according to Mr. Spitzer, to the detriment of [mutual] funds’ long-term investors,” and contrary to assurances that such investors receive through the funds’ prospectuses.

Mr. Spitzer, who was restating the points he had made the day before to the Senate Committee on Governmental Affairs, subcommittee on financial management Previous HedgeWorld Story was not mollified by the contention that mutual fund directors might not have been aware that such practices are underway at their funds, and he described three “red flags” they might have noticed: the high ratio of total redemptions to average net assets (at one of the funds in which Canary was trading, this ratio was 17 to one); the very close correlation between sales and redemptions; and the fact that many hedge funds have been quite open about their use of mutual fund timing. Mr. Spitzer cited a study by four professors at New York University, published last summer, who said that they knew of at least 16 hedge fund companies managing 30 hedge funds that gave “mutual fund timing” as their stated strategy. But since directors are beholden to fund managers and advisers, Mr. Spitzer charged, such red flags had no effect.

Stephen M. Cutler, director of the Securities and Exchange Commission’s division of enforcement, also testified to the Senate panel Monday and the House panel Tuesday. He was more expansive than Mr. Spitzer had been on the question of why market timing is an abusive practice:

“Dilution [of the value of mutual fund shares] could occur if fund shares are overpriced and redeeming shareholders receive proceeds based on the overvalued shares. In addition, short-term trading can raise transaction costs for the fund, it can disrupt the fund’s stated portfolio management strategy, require a fund to maintain an elevated cash position and result in lost opportunity costs and forced liquidations. Short-term trading can also result in unwanted taxable capital gains for long-term shareholders and reduce the fund’s long-term performance.”