Friday, November 30, 2012

Win-Win-Win-Win becomes Lose

Win-Win-Win-Win becomes Lose

Yesterday I described a fantastic business opportunity for a big bank. An investor traded in and out of the firm’s mutual funds, including trades executed after-hours, while using a bit of its own capital and a loan from the bank.  The investor was a hedge fund called Canary, and the bank was Bank of America.  Over more than two years beginning in 2001, Canary executed 8,300 trades in and out of Nations Funds, BoA’s mutual funds. 

Bolt-Ons (2008)

As I mentioned yesterday, the bank earned all sorts of fees from this relationship.  Bank of America Capital Partners (BACAP), the advisor to the fund, earned $4.1 million in fees on Canary’s trades.  BACAP also earned another $267,000 in management fees from the assets invested by Canary in other funds.  The bank’s mutual fund distributor earned $113,000.  BA Securities, the broker, earned $7 million executing other stock trades for Canary.  And Bank of America’s private bank earned about $1 million from providing between $75 million and $125 million in credit to Canary so it could make its timing and late trades using the borrowed funds. 

How come we know all these details?  Bank of America was forced to settle with the SEC in 2004, pay a fine of $235 million, and roll back fees for 5 years.  The late day trades were simply illegal.  Canary wasn’t profiting from the markets, it was simply taking profits that belonged to mutual fund investors.  The market timing trades weren’t illegal per se.  Rather, the short-term trades violated fund policies established by the mutual fund board, and BACAP failed to tell the board about the thousands of trades executed by Canary.  Bank of America had a lame excuse for failing to inform the mutual fund board.  The bank claimed that it would have violated client confidentiality.  Canary’s frenetic activity cost the regular investors a great deal.  Thanks to the hedge fund, the effected mutual funds had excessively high turnover (lots of transaction costs) and unusually large short-term capital gains, all of which were borne by the mutual fund investors.

How did the SEC find out about this transgression?  An employee of Canary named Noreen Harrington tipped off New York State Attorney General Elliot Spitzer, who quickly discovered that a bunch of mutual funds were permitting Canary and a few other hedge funds to engage in these practices.  Before long, the SEC and Attorney General were digging through emails.  Bank of America was far from alone in granting a hedge fund special access to its funds.  Alliance Capital, Bank One, Invesco, Janus Funds, and Putnam were among the large fund complexes caught up in the scandal.  In fact, Bank of America got hit twice because it acquired Fleet Financial, whose mutual fund, Columbia, had been doing the same thing.  

Two culprits deserve special mention.  Both these individuals were icons of the money management business.  Gary Pilgrim was a highly successful growth investor who founded Baxter, Pilgrim, and Associates, and Richard Strong was an equally successful value investor who established Strong Capital.  As it turns out, Mr. Strong had been market timing his own mutual fund, in addition to permitting Canary to engage in the practice.  And Mr. Pilgrim had allowed a hedge fund to trade his funds in which he had a 45% stake.

Having worked in a large financial conglomerate, I can envision how the pressure from senior management pushed executives to enter into these improper relationships.  I’m sure they were desperate to achieve their profit plan.  It’s harder to understand Messrs. Strong’s or Pilgrim’s motivation.  These guys were rich beyond their wildest dreams.  Perhaps it is the amoral environment of money management that led them to screw their clients in order to make themselves just a little bit richer.

Thursday, November 29, 2012

Four winners: Can You Spot the Loser?

Four winners: Can You Spot the Loser?

A stockbroker receives the following proposition: I’d be willing to invest a large sum in one of your mutual funds and send you a slew of other stock trades if you let me trade in certain of your mutual funds and occasionally place a late day order.  The investor is particularly interested in technology-oriented, international, emerging market and small cap funds.  The broker works for a bank that sponsors a complex of mutual funds.  As you can imagine, the broker is excited because he stands to make tens of thousands of dollars in commissions.

Takeover (2007)

He takes the proposal to the management of the brokerage firm, who in turn, sets up meetings with the mutual fund distributor (another arm of the bank) and the sub-advisor (still another part of the bank that actually manages the money).  The mutual fund distributor is pretty excited about the proposal because it means higher fund balances and more fees.  The sub-advisor is lukewarm about this idea because the investor’s cash will be continually sloshing in and out of certain funds, creating pressure to quickly buy and sell securities.  This creates a lot of pressure on the portfolio managers.  However, this is a win-win-win.  The brokerage firm will make commissions and trading profits.  The distributor will earn a bunch of additional fees.  And, the sub-advisor will get more management fees.

 The investor has one additional requirement.  While his investment strategy is sure to generate profits, the individual profits are quite small.  In order to magnify the returns, the investor will require a loan from the bank.  This is no problem at all.  The bank is more than happy to earn interest and fees on the loan.  As a result, the bank is looking at the golden nugget of banking: a win-win-win-win from one client.  The investor needs just one additional small favor: a timely list of the securities in the mutual funds.

And so it begins.  The investor starts submitting all sorts of buy and sell orders for three or four of the most volatile mutual funds.  The back office, which has to process all these trades, is overwhelmed.  The portfolio managers starts stressing out because they never know when they’re going to receive a pile of cash or have to raise a pile of cash.  And, compliance has woken up to the fact that the prospectus limits the number of permissible trades in a mutual fund in a given time period.

The investor has become too important to curb this activity.  In order to make it easier for the investor to enter trades, the broker arranges for the investor to have an automatic order entry system installed in the investor’s office.  The distributor decides to grant the investor a waiver from the usual trading limits, so the compliance issue goes away.  The portfolio manager is still grumpy, but he can use derivatives to manage the cash flows.

What’s the investor’s strategy all about?  The rapid trading has several multiple purposes.  A piece of the strategy is market timing.  The mutual fund is a convenient way to quickly create and eliminate exposure to certain sectors of the market (note: exchange traded funds have supplanted this advantage). 

Another part of the strategy is to capture anomalies between the value of the mutual fund and the value of securities in the portfolio.  This works particularly well in international and emerging market funds.  While the mutual fund is priced at 4pm when US markets close, international funds trade in different time zones.  This means that there may be a built in profit or loss in the mutual fund.  For example, suppose US stocks have a huge rally and close up 2%.  It is pretty likely Europe will follow suit and rise in tomorrow’s trading.  However, the rally in Europe won’t be reflected in mutual fund prices until tomorrow.  So the investor would buy a European fund today and sell tomorrow when the European markets catch-up to the US rally and are reflected in the mutual fund’s price.  There’s some risk that the investor has mistimed the markets or that Europe doesn’t rally, but more often than not the investor will profit.

The third strategy is a sure-fire way to make money.  It’s late day trading.  The idea is to place orders after the deadline for putting in mutual fund orders.  Late orders aren’t unusual.  During the day, brokers are prone to make mistakes (e.g., buys that should have sells, or orders for 10 shares that should have been 100 shares).  What the investor had in mind is quite different and is best explained by an example.

Suppose a company held in a mutual fund announced important news after 4:00 pm, such as an earnings announcement or merger.  The company’s stock would move up or down, but would not be reflected in the mutual fund’s NAV until the following day.  The mutual fund was priced at an NAV of $10.00 and owned a 5% position in ABC Tech Company.  ABC reported a fantastic quarter, and the stock goes up 10% in after hours trading.  Thus, we have a very good idea that the NAV is going to rise to $10.05, or maybe even more as all the technology stocks in the portfolio are likely to get a boost.  However, this improvement won’t be reflected until 4:00 pm tomorrow, when the investor will sell.  With late day trading privileges, the investor can grab hold of that nickel because he’s allowed to purchase the mutual fund at $10.00.  Moreover, the gain is magnified because a hefty part of the purchase price came from the bank’s loan.

Who loses?  You can probably guess.  But we’ll leave the fallout until tomorrow.

Wednesday, November 28, 2012

Mutual Fund Investors versus Banks: The Bank Wins

Investors versus Banks:  The Bank Wins

You probably think of your mutual fund holdings as an investment.  You wire cash into the account, and a portfolio manager strives to meet your objective for capital appreciation, income, or capital preservation.  However, the executives who oversee mutual funds look at them as businesses opportunities.  The best part is that those opportunities can be exploited using your investment capital. 

True, the mutual fund has its own board of directors, and a majority of the board members, including its chairman, are supposed to be independent of the advisor.  In practice, the independent directors aren’t very independent at all.  While they aren’t former employees of the advisor or any of its affiliates, they usually have some prior business or social relationship with senior management.  Most mutual fund boards act as well-scripted puppets for the advisor.  The board is given reams of data and sits through endless presentations, but if board approval is required, it will be given.  Mutual fund boards only have a life of their own after something goes wrong.

Shuffling Share Classes (1999)

The advisor is interested in generating more fees.  If a bank or insurance company owns the advisor, they also want to generate more fees.  These aren’t investment organizations.  Rather, they are asset-gathering machines.  As assets flow into the mutual funds, profit margins expand, and few of the benefits are bestowed where they belong: with mutual fund investors.  In previous posts, I’ve written about the various marketing techniques used to seduce potential investors, such as highlighting “hot” performance.  I’ve also pointed out that investors pay for most of these marketing efforts.

In a financial conglomerate like a large bank, the pressure to generate more fee income is enormous.  Most bank executives are fairly far removed from the day-to-day requirements of the mutual fund business.  They simply decide that the people running the business ought to generate 15% or 20% more in profits.  At the same time, the bank executives are loath to invest the bank’s capital in building the mutual fund business.  As a result, the mutual fund executives are left to devise plans that are, at a minimum, in conflict with the best interest of their clients.  At worst, as we will see tomorrow, some of these schemes have turned out to be illegal.

Let’s return to my days at NationsBank and look at two techniques for building up mutual fund profits.  One sure-fire way to increase profits is to shift asset allocation models into higher fee products.  As I arrived at the bank, an effort was underway to add international and emerging market funds to the asset allocation.  Obviously, there’s a good rationale for international investing as it diversifies the source of an investor’s returns.  However, the bank’s true aim was to generate higher fees as domestic equity and fixed income investments were liquidated in favor of overseas investments.  Trust officers all over the country were instructed to make the switch.  By the way, the timing was absolutely awful.  NationsBank waited until international and emerging market returns had been outstanding for three or four years.  When we finally added them to our clients’ portfolios, those markets swooned.  To this day, the asset allocation trick continues to serve as a great way to boost fees.  Quick aside: I could never get never get an index fund into the asset allocation model.  I bet you can guess why.

The bank was also a great believer in common trust conversions.  Common trust funds are very inexpensive investment vehicles organized by bank trust departments.  Unlike mutual funds, they are usually not priced every day, so you cannot buy or sell at the end of each day.  They also don’t have all the marketing and administrative expenses associated with mutual funds.  At NationsBank, we systematically converted common trust funds into mutual funds, generating higher profits for the bank.  Clients got a bunch of glossy reports and daily pricing in exchange for larger fees and in some cases, a whopping tax bill.  While most of these conversions have now taken place, you still have to be alert.  Mutual fund companies are continually closing funds or share classes and transferring balances.  All too often, it is their wallet that is fattened by these actions.

About two months before I exited NationsBank, a group of mutual fund executives came to see me.  At that point I was running TradeStreet, the bank’s largest money manager, which sub-advised all the domestic mutual funds.  My desk was on the trading floor, so they insisted we find a conference room for our chat.  During the year they had signed distribution agreements with brokerage firms to sell our mutual funds.  Despite the agreements and generous sales commissions and distribution fees, the funds weren’t selling.  While the investment performance of most of our funds was competitive, why would a Merrill Lynch or Smith Barney broker want to sell a bank-sponsored mutual fund to a client?  The executives had a potential solution to this problem.  They strongly suggested that I direct a bunch of our trading volume to certain key brokerage firms, and that those firms would then feature our funds.  In a word, my answer was “no.”

The cost of trading was borne entirely by our clients, so TradeStreet’s responsibility was to achieve the best possible execution at the lowest possible cost.  This scheme looked like a case of “pay to play,” and I wasn’t going to play.  Sixty days later, I was out of the bank for entirely different reasons.  I am sure if I had stayed the issue would have resurfaced.   NationsBank was far from the only institution intent on squeezing more fees out of their mutual fund complex.

Tomorrow we’ll cross from the grey zone into the forbidden zone.

Tuesday, November 27, 2012

Conflict of Interest: When A Money Manager’s Parent is a Bank

Conflict of Interest: When A Money Manager’s Parent is a Bank

I’ve been reading John Bogle’s latest book, “The Clash of Cultures: Investment versus Speculation.”  Mr. Bogle is the founder of Vanguard Group, the largest mutually owned mutual fund company and the inventor and chief proponent of the index mutual fund.  Now in his 80s, he continues to drive home a clear message about the value of saving money and building wealth in broad-based, low cost, and simple investments.  While Mr. Bogle’s investment principles have gained wide acceptance in the past several decades, he laments that speculation and conflict of interest are more prevalent than ever in the investment business.

Thorn In Our Side (2003)

His book reminded me of some of my least pleasant experiences in managing money inside large financial institutions, and the inherent conflict between acting in the best interest of investors and generating fees and profits for the company.  While some of my stories go back ten or fifteen years, most of these practices live on. 

Let’s begin with corporate governance.  If a money manager invests in equities on your behalf, he votes on all corporate matters on your behalf as well.  Whether it’s a slate of directors, the approval of a merger, or some new stock scheme, he’s supposed to act in your best interest as he votes on these matters.  As Mr. Bogle hammers home in his book, this isn’t how money managers behave.  Many money managers pay little or no attention to corporate governance.  Money managers have a variety of reasons for cozying up to corporate executives rather than confronting them on proxy matters.  Many corporations are a potential source of business, and thus money managers don’t want to jeopardize their own business.  Sadly, if portfolio managers violate their duties, there’s no one serving as a check to CEOs and corporate directors.

Early in my stint at NationsBank, I served as Director of Research.  One of my responsibilities was to chair the proxy committee, the group that reviewed corporate governance matters.  Like most institutional investors, we cast our votes with management almost all the time.  As I recall, we opposed a few measures that had a strong tendency to entrench management, such as poison pills and staggered boards.  On all other matters, we simply followed management’s recommendations.

We held a sizable position in Kmart, which was already struggling in the mid-90s. The company had acquired Waldenbooks, Borders, Builder Square, and the Sports Authority, and management decided that the way to “create” value for investors was to issue something called “tracking stock” in each of its major subsidiaries.  Tracking stocks were mere pieces of paper (not actual ownership) that we could trade based on the value we ascribed to each of the Kmart entities.  Somehow these pieces of paper were going to be worth more than the price of Kmart’s languishing stock.

Our proxy committee thought that this proposal was a poor substitute for needed changes at Kmart.  Management had spent too much time with their investment bankers and not enough time investing in the technology and inventory necessary to compete with Wal-Mart and Target.  The proxy committee decided to vote against the Kmart proposal.  As a courtesy, I called the CFO of Kmart to let him know that we were going to oppose management’s proposal.  We had a polite and straightforward conversation.  I was still commuting back to New York from Charlotte at the time, so after phoning the CFO I headed off to the airport. 

On Monday morning I returned to my office to find my voicemail overflowing with irate messages.  It turned out that NationsBank was a significant lender to Kmart, and Joseph Antonini, Kmart’s CEO, was not pleased.  In fact, he was threatening to cut the bank out of future business.  All sorts of NationsBank executives, who I’d never heard of, had called to find out why I hadn’t checked with them first.  Other executives simply called to tell me I was stupid or worse. 

Fortunately my boss, Jim Sommers, understood that I’d acted entirely appropriately, and some how put out the fires among the bankers.  NationsBank’s business relationship with Kmart suffered.  However, as fiduciaries for our investors (folks in our mutual funds and trust department), our only appropriate consideration was to vote in the best interest of those investors.  

Later in 1994, Kmart came up with another plan and conducted an actual initial public offering of shares in Borders and Sports Authority.  However, Mr. Antonini failed to turn around the core Kmart business and was terminated in 1995.  Fortunately, my tenure at NationsBank coincided with a roaring bull market, and we didn’t face very many controversial proxy matters.  However, I always felt the enormous presence of the bank, and I knew that the bank’s interest and our clients’ interests were seldom one and the same.

Money management firms owned by large financial conglomerates are unlikely to take corporate governance seriously.  A bank or insurance company has too many reasons to maintain good relations with the very companies their investment subsidiary is investing in.  As a result, you should not expect the money manager to act completely independently from its parent.  Money managers know where their paychecks come from.

The money management business is rife with conflicts.  Tomorrow I’ll related some of those pressures inside the mutual fund business.