Sand Spring Advisors LLC
Spitzer in Action
September 2, 2003
by, Barclay T. Leib
Earlier today, New York Attorney General Elliott Spitzer announced a new crack-down on so-called mutual fund market timing conducted by sophisticated hedge funds that take advantage advantage of so-called "time-zone arbitrage" and the trading of mutual funds post the standard 4 pm. cutoff.
The specific recipient of his initial attack was a firm called Canary Partners and various arrangement that Canary had with Bank of America to allow Canary to effectively "game" BofA's own mutual fund series (called the Nations Funds) using leverage and derivatives actually provided to Canary by BofA.
A copy of Spitzer's complaint can be found here. It makes for some interesting reading.
Mutual fund timing has existed for years in this country, and according to Mr. Spitzer's complaint, allows sophisticated hedge funds to basically siphon off up to $4 billion annually from innocent (perhaps some might say dumb, or at least naive) buy-and-hold mutual fund investors who continually have their percentage holdings of underlying equity shares diluted or increased at exactly the most inopportune moments. Hedge funds are able to do this due to a single cut-off time for U.S. mutual fund redemptions and subscriptions at 4 P.M. New York time, even though foreign markets all close far earlier in the day. This sets up a statistical edge for hedge funds when late day New York volatility can be a precursor for subsequent day price trends in Europe or Asia.
Mr Spitzer's complaint is well written and factually strong. He is correct when he states that most mutual fund groups have verbiage in their prospectuses disparaging such timing attempts, and reserving the right to block trades. But the real villain in Mr. Spitzer's attack is not the savvy mutual fund timer who trades within standard business hours following standard limitations and rules. It is instead the entire brokerage community and mutual fund industry that in return for extra fee income, sticky assets left on deposit, and active derivatives trading, cut special mutual fund trading "capacity" deals to hedge funds.
In the case of Canary, it would appear BofA pulled a number of no-no's that hurt public investors in its own mutual funds, and the bank allowed this to occur principally to pad its own fee income. An open question can thus be asked why Mr. Spitzer has to date only issued a complaint against Canary and not against BofA as well. Perhaps the complaint against BoA will follow. Or perhaps a hedge fund simply represents a politically more correct target to go after, while at the same time serving to scare the hell out of the banking/brokerage community and indirectly force them into cleaning up their act.
One thing is for certain: Canary was a particularly easy initial target as this firm appears to have traded regularly post the 4 pm cutoff, while most other mutual fund timers do not have such access. While this was only a minor extra benefit for Canary that likely made them just marginal additional income, such a practice is patently illegal.
But here is the bigger risk. If the media gets its hands around this topic and it grows in importance over the coming days and weeks, Mr. Spitzer could create the next crisis of confidence in America. First there was Enron, then Worldcom, and now Mr. Spitzer may be uncovering all the malfeasance that exists in the mutual fund and banking/brokerage world -- special deals that screw the little guy to the advantage of New York big swinging dicks. Maybe this is well overdue and Mr. Spitzer should be applauded, but if Spitzer is too good at doing this, 1-800 redemptions from the public out of mutual funds could easily transpire. He obviously needs to be extremely careful as to how deep he probes.
While Mr. Spitzer's basic intentions are no doubt honorable, if he is not careful, he could indeed be the catalyst to change the public's current complacent attitude toward investing. He could be the "prick" or the excuse to cause recent neophyte equity nirvana to suddenly become unglued.
One will note already that Bank of America's stock got pounded Wednesday.
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