of the great successes of finance capital in the last
decade – and finance in American capitalism
in particular – has been its ability to draw
more and more people, including workers, into its
net. Across the developed post-industrial world, ordinary
people now have a stake in how the financial markets
are doing, simply because their personal savings for
the future is invested directly or indirectly in these
This has come about through a combination of two processes.
First, there is the demographic factor, resulting
from a change in the structure of the population,
with a greater proportion of the aged because of higher
life expectancy, and with a bulge of the post-war
baby boomers now in their prime, who need to save
for their old age. Second, there is the fact that
in many countries, governments have progressively
reduced their own pension and other commitments per
capita, and forced more people to provide their own
personal savings for the future. Just as is happening
in India today, fiscal incentives for personal savings
were continuously pushed away from bank deposits towards
more risky capital market instruments.
But capital markets – in securities and the
like – are notoriously difficult for individual
investors, and almost impossible for small investors
to negotiate successfully to ensure safe and secure
returns for the future. One response to this problem,
has been the development of mutual funds.
A mutual fund pools together the individual holdings
of small personal investors, and works with the total
sum. A mutual fund firm invests in a broad range of
stocks or other securities on behalf of a large number
of individual clients. These small investors mostly
purchase mutual fund shares through retirement plans
or other savings plans for the future. It therefore
allows small investors to diversify holdings (and
thereby decrease risk) by creating a vehicle for a
small amount of capital to be invested in a large
number of different securities.
In the heyday of the stock market boom in the 1990s,
these instruments were crucial in bringing many more
small investors into the stock market especially in
the US. Today, it is estimated that the number of
people investing in mutual funds in the United States
is nearly 100 million, which includes around half
of all households.
By now, US mutual funds alone manage as much as $7
trillion in assets, which is why these funds have
become such important players in emerging markets
across the world. Even a tiny shift in the portfolio,
of say around 1 per cent, can cause huge movements
of capital which can be deeply destabilising for any
particular emerging market. At the same time, the
rapid increase of these funds over the past decade
has provided a large and growing source of profit
for fund owners, managers, banks and brokerage houses.
Of course, mutual funds are not limited to small investors;
even larger or more "elite" investors
can invest in mutual funds. Indeed, many larger investors
often prefer these as slightly safer vehicles than,
say, hedge funds, which deal in large amounts of capital
and are restricted to large individual investors.
It is the possibility of making a difference between
the millions of small investors who invest in mutual
funds, and the larger more powerful or more knowledgeable
investors, which is at the heart of the latest big
financial scam in the US.
In the past month, the US Securities and Exchange
Commission (SEC) and state regulators in New York
and Massachusetts have brought charges against several
large and influential mutual funds and their managers.
The companies include the mutual fund giant Putnam
Investments, the brokerage firm Prudential Securities,
Alliance Capital Management, and a series of smaller
mutual fund companies. Individual brokers and executives
at some of these firms are facing criminal charges,
while the mutual funds themselves face civil fraud
Just as happened with Enron and the series of corporate
scandals which broke out in America two years ago,
the matter is now snowballing as more and more firms
get implicated. What began as an enquiry against a
single hedge fund by the New York regulator Eliot
Spitzer (who was also instrumental in prosecuting
Arthur Anderson accounting company during the Enron
scandal) has now engulfed almost the entire mutual
The basic accusations concern "market timing"
and illegal late trading of mutual fund shares, both
of which benefit an elite group of investors and fund
managers at the expense of millions of small investors.
Both of these are manipulations made possible by the
peculiar way in which mutual funds are priced.
Unlike many other stock market-based financial instruments,
mutual funds are not priced continuously on the market.
Instead, at the end of each trading day (4 p.m. Eastern
Standard Time), the total value of the fund’s
investments is calculated and this figure is divided
by the number of outstanding fund shares, yielding
the price per share. An order to buy or sell a share
in a mutual fund is held until the end of the day,
when it is processed at the closing price. The purpose
of this is to prevent investors from taking advantage
of the very temporary movements in price over the
However, this has created the possibility of "market-timing",
a process by which an investor takes advantage of
the fact that the price of a mutual fund is determined
by the closing value of the shares owned by the fund,
regardless of when this closing value was actually
determined. Thus, for example, international stocks
and shares owned by the fund are priced at the value
of the stock at the time of the closing of the market
in which they are traded, which can be hours before
the closing of the US markets. This is true of all
Asian and European stocks, for example.
Since there are such large time differences involved
and markets close at very different times across the
world, there could be events or information which
comes through to reveal to investors that actual value
of the international shares is different from the
closing (or "stale") value. Therefore,
the real value of the mutual fund may be quite different
from the calculated value at the close of the trading
day. This provides a tremendous opportunity for profit,
especially for insiders of fund managers, who can
take advantage of information that is not available
to ordinary retail investors.
The other practice that has been used to deprive small
investors of returns at the cost of a favoured group
of insiders of elite investors is known as late trading.
In this case, managers can benefit particular selected
clients by processing orders as if they were placed
before the close of the trading day, instead of later.
This is because orders usually take several hours
to process, so that trades are usually allowed to
go through to the mutual fund well after closing,
as long as the original order was placed before the
close of the trading day. So brokers can simply declare
that a particular order was placed earlier.
This practice is more than a bending of the law, it
is strictly illegal, although extremely difficult
to monitor and regulate. But both of these practices
do more than provide windfall profits for a small
group of favoured investors or even insider managers
themselves. They also affect the total value of the
mutual fund and therefore the return to small investors.
Whenever an investor sells at a price above the true
market value of the fund’s shares or buys at
a price below the market value, the difference must
be absorbed by the mutual fund itself. This means
that the total value of the assets owned by the fund,
and therefore the value of each individual holding,
must go down.
It is now clear that these practices were not restricted
to a few unscrupulous mutual fund managers, but were
actually widespread across the hedge fund and mutual
fund industries. Every week since September, when
the first accusations against a hedge fund were made
by Eliot Spitzer, new firms have come up for scrutiny
and been found wanting. Clearly, therefore, millions
of small investors in the US who invested in mutual
funds have lost some savings by virtue of these sharp
The SEC has already been criticised for its inactivity
and ignoring of such fraudulent practices, which raise
many parallels with the earlier Wall Street scams.
A recent settlement of SEC with Putnam, the fifth
biggest US fund manager, has been denounced by Spitzer
and other regulators, for not going far enough. Without
admitting wrongdoing, Putnam has agreed to "governance
reforms" and to pay restitution to investors
who lost money as a result of its employees' improper
trading. This is tantamount to administering only
a light slap on the wrist for very serious financial
While some individual managers are being punished
by losing their jobs, the extent of punishment is
not likely to be a deterrent to such activity by others
in the future. This is especially true when even those
who are forced to leave still make windfall gains
in the process. For example, the CEO of Putnam, Lawrence
Lasser, is due to receive $89 million in parting pay.
He was already one of the highest paid executives
in the industry, receiving over $100 million in pay
and bonuses over the past five years.
All this reinforces the arguments that are now well
known, that financial markets are prone to all sorts
of imperfections resulting from incomplete and asymmetric
information in particular, and that these can give
rise to very serious malfunctioning and wrongdoing.
It is also increasingly clear that adequately regulating
undesirable practices is difficult if not impossible,
given the ability of the markets to develop new forms
of malpractice, and the close social and political
nexus that tends to exist between financiers and those
who are meant to monitor them.