Ethics in Mutual Fund Management: Conflicts and Reform

Introduction: Ethics as the Foundation of Financial Law

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, and 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 remain unethical. Lord Moulton, a nineteenth-century English jurist, when asked to sum up the relationship between law and ethics, said that 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 even when they are not legally enforceable, and ethical behavior often exacts a high price.

The beginning of the twenty-first century is a skeptical time. The public's ability to trust is difficult to maintain amid a pervasive and uncomfortable feeling 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 genuine commitment to ethical behavior (Davis, 2003).

The Mutual Fund Scandal and the Call for Reform

Nowhere is the need for ethical leadership 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 began to come down. The legislative, regulatory, and market reforms that were 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 the time being, 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). Congress is also pressing ahead, with the SEC racing to keep pace. Each of these groups is acting for the benefit of the people who have invested over $7 trillion 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 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 shares (Borrus & Dwyer, 2003), to require disclosure on a semi-annual basis of dollar-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 to require investment advisers to adopt and vigorously enforce codes of ethics for their employees (Hume, 2004).

There are a number of important ethical issues that have been ignored by mutual fund managers and their firms — issues of great concern to investors, and now to legislators and regulators as well. All of them should and must be addressed. Some new behaviors will be mandated by 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 from mutual fund firms — and simply not investing in those that will not provide appropriate information.

The main areas of concern addressed in the following sections include conflicts of interest, director independence, and transparency of fee and expense reporting.

Conflicts of Interest in Mutual Fund Management

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 truly able to understand the performance of their investments, the following questions 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 funds 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 existing investors. By putting uninterrupted growth of fees ahead of the health of investor returns, firms that 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 develops a promising investment idea, the temptation is to put it into their hedge fund, where it can earn a higher return (due to buying on margin) and command a much larger fee (Zweig, 2004). Some firms claim to minimize this conflict by not allowing the same people to run both a basic mutual fund and a hedge fund. Whether this is sufficient to prevent the practice is questionable, but it is at least a start.

Does the firm utilize fair-value pricing to discourage market timing and forbid late trading? Few mutual fund firms have taken any steps to curb trading abuses. Nearly all mutual fund firms acknowledge that 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 funds vulnerable to market timers who seek to trade on stale prices, buying fund shares at outdated prices and selling them a day or two later. A few firms 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. Even so, very few firms actually enforce such a policy. Another widespread abuse is late trading, where fund shares are bought and sold after 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 targeted by market timers is to calculate its redemption rate, which reveals how long shareholders hold 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 result to a percentage 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 a year. A high redemption rate does not automatically mean that market timing is occurring, but it is a definite red flag.

Does the mutual fund firm require employees to hold shares in their own funds for a minimum period, or even to invest in the firm's 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). Most firms do not prohibit employees from investing outside their own company's funds — when fund managers have a promising investment idea, it does not necessarily stay inside their own fund or even their own company. Until the SEC mandates better disclosure, it is impossible to determine how much money fund managers have invested in the funds they run. A related question is whether the firm allows its fund managers and principal underwriters to conduct short-term trading. The answer investors should 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 sales tactics (Weinberg & Lambert, 2003).

Does the firm have an official code of ethics? The fund, its investment advisers, and its principal underwriters should have a strictly enforced code of ethics to prevent abusive transaction practices (Coffin, 2004).

Conclusion: Investor Responsibility and the Path Forward

Business ethics are becoming increasingly important to investors in the wake of the parade of corporate ethical disasters. Investors are more and more likely to vote their conscience with their wallets. To accomplish that intelligently, however, 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. "Obedience to the unenforceable" — to be truly ethical requires all of us to adhere to a higher standard: not to do only what we must, but to do what we should.

Unfortunately, with the enormous amount of money at stake in the mutual fund industry, the temptation has been great and the punishment has not served as a sufficient disincentive. Much of what will happen now is in the hands of Congress and the SEC. New behaviors will inevitably result, but the biggest impact should come from better-educated investors who take responsibility for their own investments — and vote with their wallets.

References

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