One Person's View on the Ethics in Financial Management

¶ … conflict of interest is at the core of nearly every ethical dilemma. A conflict of interest, simply put, is a situation in which the decision maker has two or more competing interests. Market timing, late trading, insider trading, illegal trading, fraud, partial disclosure, non-disclosure...the manifestation of conflicts of interest is seemingly endless. The business landscape today is a minefield of ethical disasters, some of which have already occurred, some of which wait quietly in the shadows to erupt into scandal.

In the summer of 2002, when Congress was attempting to decide how to clean up the shady financial practices of Corporate America, mutual fund company lobbyists convinced lawmakers to exempt their area of the financial services industry. As of September 2003, when the Attorney General for New York State, Eliot Spitzer, revealed his "stunning" charges of illegal trading in mutual funds, this industry has occupied center stage in the spotlight being shone on ethical problems in financial management.

There are a number of important ethical issues which have been ignored by mutual fund managers and their firms; these are issues that are of great concern to investors, and now legislators and regulators as well. The main areas of concern, which are addressed in detail in this paper, include conflicts of interest, director independence and transparency of fee and expense reporting. Investors are more and more likely to vote their conscience with their wallets. To accomplish that requires a clear understanding of all the issues.

To acquire a clear understanding of all the issues requires shining the light much more brightly on the areas outlined in this paper. One Person's View on the Ethics in Financial Management conflict of interest is at the core of nearly every ethical dilemma. A conflict of interest, simply put, is a situation in which the decision maker has two or more competing interests (Davis, 2003). Market timing, late trading, insider trading, illegal trading, fraud, partial disclosure, non-disclosure...the manifestation of conflicts of interest is seemingly endless.

The business landscape today is a minefield of ethical disasters, some of which have already occurred, some of which wait quietly in the shadows to erupt into scandal. Clearly, something more than the conventional approach to ethics is needed. Enron failed to benefit from its own 64-page ethics code or an audit committee that included both the retired dean of a business school and the former chair of the Commodity Futures Trading Commission (Davis, 2003).

What was missing was a policy requiring board members to raise ethical issues whenever they had questions and to request the advice of independent third parties. Ethics is much more than simply obeying the law (Davis, 2003). An action can be technically legal, yet unethical. Lord Moulton, a 19th century English jurist, when asked to sum up the relationship between law and ethics, said ethics is "obedience to the unenforceable." Laws grow out of the ethical convictions of the people who make and enact them.

The very essence of human civilization has resulted from the combined experiences of mankind over the millennia, in which various laws have been recognized as being ethical and appropriate. According to Davis, the history of jurisprudence acknowledges a common law of this sort, established in social practices rooted in a dim and distant past but still significant enough to be a guide for positive law.

However, because of the enormous cultural changes taking place in the world today, it becomes increasingly difficult to apply this ethical framework to new moral situations. Certainly ethical standards evolve over the ages, from one generation to the next and sometimes within the same generation. Therefore, as opposed to being an extension of the law, ethics is the law's very foundation (Davis, 2003). Ethical decisions have the power to change behavior, despite not being legally enforceable. Ethical behavior often exacts a high price.

The beginning of the 21st century is a skeptical time. The public's ability to trust is difficult to maintain with a pervasive and uncomfortable feelings that government leaders have been deceptive. Newspapers have apologized for misleading readers. Major corporations have filed false financial statements. Members of the clergy have abused parishioners. To preserve trust, business leaders and politicians must take the initiative to demonstrate a commitment to ethical behavior (Davis, 2003). Nowhere is this clearer today than in the field of financial management.

In the summer of 2002, when Congress was attempting to decide how to clean up the shady financial practices of corporate America, mutual fund company lobbyists convinced lawmakers to exempt their area of the financial services industry.

The funds' six decades of apparent scandal-free operation lulled Congress into obliging them, excusing funds from the more onerous provisions of the Sarbanes-Oxley corporate reform law; however, as of September 2003, when the Attorney General for New York State, Eliot Spitzer, revealed his "stunning" charges of illegal trading in mutual funds, this industry has occupied center stage in the spotlight being shone on ethical problems in financial management (Borrus & Dwyer, 2003). Hard on the heels of this spreading scandal, the Congressional hammer is coming down.

The legislative, regulatory and market reforms that are in the works could add up to an overhaul as large as that of Sarbanes-Oxley, with an even more immediate impact on American investors. For now, it is the state treasurers, pension fund trustees and 401(k) plan managers, with billions invested with fund companies, who are doing the most to shake up the industry (Borrus & Dwyer, 2003). Further, Congress is steaming ahead with the SEC racing Congress to the finish line.

Each of these groups is acting for the benefit of the people who have invested over $7 trillion dollars in mutual fund assets. The SEC is considering new rules to halt market-timing and other trading abuses.

Between them, the SEC and Congress are also addressing measures to strengthen fund boards, to give fund investors better information about portfolio holdings, to require portfolio managers to reveal their own trades in fund (Borrus & Dwyer, 2003), to require disclosure on a semi-annual basis of "dollars-and-cents" amounts of fees and expenses that investors pay, to prohibit funds from using brokerage commissions to pay broker-dealers for selling fund shares, to prohibit individual fund managers from overseeing hedge funds, and finally, to require investment advisors to adopt and vigorously enforce codes of ethics for their employees (Hume, 2004).

There are a number of important ethical issues which have been ignored by mutual fund managers and their firms, issues that are of great concern to investors, and now legislators and regulators, as well. All of them should and must be addressed.

Some new behaviors will be mandated by the new rules, some by the firms themselves and some things will only change as a result of investors being better educated and demanding greater disclosure by mutual fund firms and simply not investing in those that will not provide appropriate information. The main areas of concern, which are addressed in detail in the following pages, include conflicts of interest, director independence (which also includes obvious conflicts of interest) and transparency of fee and expense reporting.

Conflicts of Interest The critical conflicts of interest encompass a broad range of issues within the mutual fund industry.

In order for investors to be fully informed, and therefore, able to truly understand performance of their investments, the following information should be analyzed: Are the firm's funds closed to new investors at some set investment level? While taking in unlimited amounts of investment will raise the fund manager's fee income, it will often be detrimental to the performance of funs focusing on less liquid markets, such as junk bonds, foreign stocks or small stocks (Zweig, 2004). Closing a fund to new investment most often improves returns for the existing investors.

By putting uninterrupted growth of fees ahead of the health of investor returns, firms who do not close their funds engage in a clear conflict of interest. Does the management firm include hedge funds in its portfolio? Of major concern is the practice of allowing market timers - speculators - into a fund in exchange for deposits into hedge funds that the firm also manages. Hedge funds create a clear conflict of interest, by speculating with borrowed money and charging high fees.

If a money manager comes up with a good investment idea, the temptation is to put it into their hedge fund, where it can earn a higher return (due to being able to buy on margin) and a much larger fee (Zweig, 2004). Some firms claim to minimize this conflict by not allowing the same people to run a basic mutual fund and a hedge fund. Whether this is enough to prevent the practice is questionable, but at least it is a start.

Does the firm utilize fair-value pricing to discourage market timing and forbid late (after hours) trading? Few mutual fund firms have taken any steps to curb trading abuses. Nearly all mutual fund firms say they could use fair-value pricing in non-liquid markets like junk bonds or foreign stocks (Zweig, 2004). This procedure updates the price of securities to reflect information that emerges after the market closes. Unfortunately, most firms do not actually use fair-value pricing to eliminate opportunities for arbitrage.

This leaves the funds vulnerable to market timers who seek to trade on, or arbitrage, stale prices, by buying fund shares at outdated prices and selling them a day or two later. A few firms actually do use delayed or confirmed exchanges to discourage speculators, forcing them to wait up to seven days to move money from one fund to another. Here again, though, very few firms actually enforce this sort of a policy.

Another widespread trading abuse is late trading, where fund shares are bought and sold after the markets close. This practice is not only unethical, it is illegal (Hume, 2003). Is the fund the victim of market timing? One way to spot a fund at risk of being the target of market timers is to calculate its redemption rate, which reveals how long shareholders hang onto their stake in the fund (Tergesen, 2004).

This information is available in the fund's most recent annual or semiannual report under "Notes to Financial Statements." Dividing the dollar value of the fund's redemptions (shares reacquired) by its average assets during the same period and converting the number to a percentage (multiply by 100) reveals the redemption rate. A redemption rate of 100%, for instance, is the equivalent of every investor turning over their shares in the course of the year.

A high redemption rate does not automatically mean that there is market timing going on, but it is a definite red flag. Does the mutual fund firm require employees to keep the shares they own in their own funds for a minimum holding period, or even to invest in their own funds at all? While mutual fund companies heavily advertise the virtues of long-term investing, it appears that fund managers do not come close to practicing what they preach (Zweig, 2004).

Taking this a step further, most firms do not prohibit employees from investing outside their own company's funds - when fund managers have that brilliant investment idea, it does not necessarily stay inside their own fund, or even company. Until the SEC mandates better disclosure, it is impossible to discern how much money fund managers have put into the funds they run. Another issue here is whether the firm allows its fund managers and/or principal underwriters to conduct short-term trading. The answer to look for is no.

Are brokers being paid an incentive to push in-house funds? More than one brokerage house has been accused of cheating mutual fund investors out of several million dollars through high-pressure tactics (Weinberg & Lambert, 2003). Does the firm have an official code of ethics? The fund and investment advisers, as well as the principal underwriters, should have a strictly enforced code of ethics to prevent abusive transaction practices (Coffin, 2004).

Director Independence There is a notable lack of independence among the members of the boards of directors who are supposed to be making sure mutual funds are run in the best interest of the investors. The watchdog role of a fund's board of directors theoretically includes not only watching the big picture, but also the minutiae of the funds' service contracts, operations and investment policies.

These board members should be free of potential conflicts of interest in order to play the biggest role possible in making sure the best interests of their funds' shareholders are served. Some of the critical areas to be analyzed here include: How many board members are independent? It is important to know how many board members are relatives of the fund managers, are former executives of the management company or are collecting consulting fees from the firm (Zweig, 2004).

The SEC currently provides a glaring loophole, allowing even the former chairman of a fund management firm to be considered independent only two years after leaving the company. How are the board members compensated and are they required to make any minimum investment in the funds they oversee? Only two fund families in the top 100 pay directors with fund shares instead of cash, while only eight require directors to invest a minimum amount in the funds they oversee (Zweig, 2004).

Requiring that directors be paid with shares and requiring them to invest their director's fees in their funds along with the general public might help them to understand how investors expect to be treated. Instead of behaving as though they are employees of the management company, directors might actually think like owners of the funds they oversee. Do board members meet without fund management being present? Directors' independence is vastly enhanced when separate meetings take place for consideration of contracts, fee increases and claims against either advisers or affiliates.

Does is take a majority of independent directors to nominate and elect new independent directors? Control of the nominating process dispels any notion that directors are handpicked by the manager and not truly independent. Transparency of Fees and Expenses The job that has been done of supervising fees and expenses for Mutual Funds is appallingly bad. The average net profit margin at publicly held mutual fund firms was 18.8% in 2002, compared to a 14.9% margin for the financial services industry overall and 3% for the S&P 500 (Weinberg & Lambert, 2003).

In comparison, the average actively managed equity fund has returned only 5.3% annually over the past 10 years. The mutual bund business grew 71 times over in the two decades through 1999, but costs as a percentage of assets rose by 29%. This industry simply tossed economies of scale out the window, charging more per dollar invested as fund assets have grown.

The critical cost elements which affect the performance of a mutual fund, are generally not fully disclosed (or sometimes disclosed at all) to investors, but are necessary to a full analysis of fund performance include the following: Is there a fund breakpoint? At some point, investor expenses should be reduced by virtue of the fund growing larger and more efficient (Zweig, 2004). Economies of scale...remember them? What are the soft-dollar numbers and are they included in management fees? High fees are only part of the cost picture.

Mutual funds also run up trading charges averaging five cents per share, which is five times the rate paid by retail investors to an online discounter. The funds paid these fees because the currency was so-called soft dollars. Soft dollars were devised as a way for funds to compensate brokerages for securities analysis by sending commission business their way (Weinberg & Lambert, 2003). Today, soft dollars are a $1 billion-a-year business. They are fundamentally a rebate on commissions in exchange for directing trades to the brokerage firms (Anand, 2003).

Fund managers have been accused of using soft-dollar kickbacks to pay for a range of items that have nothing to do with the fund they are charged with managing, including rent, interior decorating and concert tickets. Funds also use their commission dollars to reward brokers for bringing in new clients. The abuse has been so bad that the Financial Services Authority, the British equivalent to the SEC, called for banning soft dollars outright early in 2003 (Weinberg & Lambert, 2003).

What is the quantity discount on sales commissions for fund investors and is this being granted automatically to qualifying investors? The industry has often been guilty of failing to grant the discounts that customers are promised (Weinberg & Lambert 2003). A study of 43 brokerages found that nearly a third of fund.