ETHICS IN lNVESTING

When Mutual Funds Behaved Badly For nearly 95 million Americans who own them, mutual funds are a convenient and relatively safe place to invest money. So it came as a big shock to investors in September 2003 when New York Attorney General Eliot Spitzer shook the mutual fund industry with allegations of illegal after-hours trading, special deals for large institutional investors, market timing in flagrant violation of funds' written policies, and other abuses. Nearly 20 companies, including several large brokerages, were dragged into scandals. Some of the abuses stemmed from market timing, a practice where short-term traders seek to exploit differences between hours of operations of various global markets. For example, when the U.S. market rallies on strong economic news, short-term traders buy shares of U.S.-based international funds with large Asian holdings just before the close of the market at 4:00 P.M. EST. Prices of these funds, often calculated between 4:00 and 6:00 P.M., reflect closing prices of the U.S. securities but previous-day prices of Asian stocks, which typically don't close until 2:00 A.M. When the next-day Tokyo and other Asian markets rallied following Wall Street's lead, the market-timers sold shares of Asian holdings at the higher price, pocketing the profits. Most funds prohibit this kind of activity, yet exceptions were made for large institutional investors who traded millions of dollars' worth of fund shares. According to the regulators, this practice resembles betting on a winning horse after the horse race is over. Although late trading is illegal, many mutual funds did not enforce that rule for some of their privileged clients. The abuses did not stop there. The National Association of Securities Dealers and the SEC also cracked down on mutual fund sales practices that overcharged investors on sales charges, or loads. Also, several funds closed to new investors charged their existing shareholders millions of dollars in marketing and sales fees. Without at all excusing this unethical behavior, unlike the accounting and management fraud at companies like Enron and WorldCom, which caused their investors substantial losses, the mutual fund improprieties have not caused significant financial damage to their shareholders. Some estimates put the cost at about 0.1% of over $7 trillion invested in mutual funds. Most of that will be recovered since—as a result of settlements reached with the regulators—many mutual funds pledged to cut fees and lower fund expenses to benefit investors in the long run.

Please answer the question

CRITICAL THINKING QUESTION The SEC has proposed several regulations intended to curb mutual trading abuses. They include strict enforcement of trading hours and the imposition of 2% redemption fees if a fund is sold in less than 90 days. Do you think this will eliminate trading abuses?