Fund Group Investigations Spell Trouble

Physician's Money Digest, October15 2003, Volume 10, Issue 19

The big picture:

This month, New York AttorneyGeneral Elliot Spitzer broughtallegations against a number ofmutual fund groups for allowing institutionalinvestors to trade after the markethad closed. Trading afterthe market has closed is similar to placinga bet after a horse race has ended.

The initial investigation centers onCanary Capital Partners, a hedge fund,and 4 big-name fund companies: Janus,Bank of America's Nations Funds, BancOne, and Strong Funds. Is this the beginningof a bigger story or does the problemstop with these 4 companies? Thereis speculation that there are many morefund companies involved.

Financial Shenanigans

Canary Capital Partners negotiatedlarge deposits and fees in exchange forthe mutual fund companies' agreementto allow them to trade after the markethad closed for the day based on the day'sclosing prices. This let them buy or sellbased on news that broke after the marketshad closed, thereby giving them apeak behind the curtain to see whatwould likely occur when the marketsopened the next day. Not only is thisincredibly unfair to the existing shareholders,but it's also illegal.

A second, less significant issue is thatthe fund companies allowed CanaryCapital Partners to actively trade (ie, buyand sell) shares of their funds. This is apractice that most mutual fund companiesdiscourage or prohibit their fundinvestors from doing. It can potentiallyincreases the taxes that fund holdersmust pay because mutual fund companiesdistribute their capital gains eachyear to all of their shareholders.

What these mutual fund companiesdid was create a preferred class of customer,giving them advantages not availableto other investors. Attorney GeneralSpitzer estimated that these practiceshave cost everyday investors millions ofdollars. In fact, Canary Capital Partnershas agreed to a $40-million settlement.In a time when corporate governance isa prominent issue for corporations,investors, and our government, thisactivity is inexcusable and the personsresponsible should face jail time.

Investor Recommendation

Morningstar (www.morningstar.com),the premier independent rating servicefor mutual funds, has issued a "sell" recommendationfor all 4 of the mutualfund companies involved in the tradingscandal. Before you decide to takeMorningstar's advice and sell, make sureyou review the tax consequences. If youhave a large gain, you should considerthe timing of your sale. If you have losses,this would be a good time to convertunrealized losses into realized losses andmove your money to another fund.

If Spitzer's investigation continuesand his discoveries turn into a majornational story, there could be a mass exodusfrom these mutual fund companies.The last thing that you want is to be thelast remaining investor. To prevent thisfrom happening, take the necessary timeto think about what your next moveshould be. If you are able to figure outthe best course of action today, tomorrowshouldn't pose a problem.

Stewart H. Welch III, CFP®, AEP,founder of the Welch Group, hasbeen rated 1 of the nation's topfinancial advisors by Money,Worth, and Medical Economics.He welcomes questions or commentsfrom readers at 800-709-7100 or www.welchgroup.com. Reprinted with permissionfrom the Birmingham Post Herald. This articlewas taken, in part, from J. K. Lasser's NewRules for Estate and Tax Planning (John Wiley &Sons; 2001), coauthored by Harold Apolinsky,Esq, and Mr. Welch.