FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted June 1, 2003) [Archive Table of Contents]

Ron Baron's Illegal Stock-Trading Strategy of the Month

Ron Baron runs the Baron funds, and last month we reported that Baron had been disciplined by the SEC for "marking the close," an illegal type of trading activity in which he attempted to manipulate the price of a stock that he owned. We were surprised that Baron received a ridiculously light fine. We were even more surprised that he wasn't suspended from the securities business, especially since the SEC had audio tapes of Baron instructing his employees to break the law (Baron was also busted several years ago for questionable trades between his funds and private accounts). But we quickly realized this travesty of justice could be an opportunity for FundAlarm. Since FundAlarm is always looking for original material, and Baron appears to be a master of legally marginal behavior, we asked Mr. Baron if he would be willing to share his extensive knowledge of illegal stock-trading techniques with FundAlarm readers. Below, we're pleased to present Mr. Baron's first essay. His subject is illegal "wash trades" -- what they are, and how you can use them to manipulate the markets for your own financial advantage.

Baron:
The master speaks

Thanks, Roy, for giving me the opportunity to share my knowledge of illegal trading activity with FundAlarm readers. As you noted, this month's subject is the "wash trade."

A "wash trade" sounds like a tax-motivated "wash sale," but it's actually quite different. Basically, a "wash trade" occurs any time you purchase and sell the same security within a short period of time. A wash trade has no economic reality, but it creates the illusion of trading volume, and that's when the fun begins. Suckers are attracted by the trading volume, they think something is happening at the company, and they bid up the stock for real. That's your opportunity to sell the stock at its new, inflated price -- and party!!!

Sophisticated scamsters should be aware of another use for wash trades. Let's say your broker is about to receive an allocation of a hot IPO, and you want to score some quick profits. Unfortunately, many other people have the same idea, and it can be tough to muscle your way ahead of them. Here's where wash trades can also come in handy. In exchange for a piece of the IPO, you might offer to do a series of wash trades with your broker in some plain-vanilla, blue-chip stocks. The key is to make those trades at an exorbitantly high commission rate, which effectively pays your broker for letting you participate in the IPO. Sure, this strategy will cost you a few extra bucks, and your broker could be permanently barred from the securities industry, but sometimes there's no other way to participate in an obscenely profitable IPO flip. And once the flipping is done, you'll have plenty of time -- to party!!!

Until next time, remember Baron's Rule: It's only illegal if you get caught!

Our more gullible readers should note that Ron Baron isn't really writing columns like this -- yet.

The FundAlarm Trend Watch:

Watch this trend: The SEC has been examining the hedge fund industry for more than a year and, far from finding massive problems, several SEC Commissioners seem to like what they've seen.....SEC Commissioner Roel Campos has publicly called on mutual funds to adopt more hedge-like strategies*.....Commissioner Cynthia Glassman has said that the SEC may need to consider loosening rules that govern mutual funds, allowing them more freedom in trading strategies**.....And SEC Chairman William Donaldson, who personally invests in hedge funds, has called them "a very legitimate vehicle"**.....It seems unlikely that the SEC will actively help mutual funds become more like hedge funds.....But now that the SEC has strongly hinted where it stands, you can be almost certain that mutual fund companies will start cranking out vehicles that push the limits of current fund rules.....One area where mutual funds are likely to push first: Getting the SEC to accept more aggressive performance-based fee structures.
* "SEC's Campos Urges Mutual-Fund Firms to Protect Investors," Dow Jones Newswires, May 12, 2003
** "Fund of Information" column, Erin E. Arvedlund, Barron's, May 19, 2003
And watch this one, too: "Soft-dollar" arrangements have been on the SEC radar screen for some time (see, for example, this September 1998 SEC report).....But now, with recent Congressional hearings focusing (in part) on soft-dollar deals, and few justifications remaining to support the current soft-dollar system, we seem to reaching some kind of turning point.....Soft-dollar arrangements are almost never disclosed in detail, and many are never even written down.....That's one reason investors aren't screaming about them.....But we think there's another reason that soft-dollar arrangements have thrived for so long: The soft-dollar system is so sleazy and so brazen, honest investors have a hard time believing that anything like it could be allowed to exist in our financial markets.....Let's try to explain the soft-dollar system once again, this time from the perspective of an industry insider.....Harold Bradley is a senior vice president of American Century Investment Management, and over the past 15 years he's served as a portfolio manager, head of trading, and a member of his company's Investment Oversight Committee.....In March, Bradley testified at the Congressional hearing on mutual fund industry practices, and here are some of the points he made about the current soft-dollar system (in which American Century refuses to participate):
- In 2002, American Century executed 45% of its U.S. trading at 0.85 cents per share (yes, that's less than a penny).
- The average industry commission rate remains between 5.1 cents and 5.5 cents per share.
- Since all commissions are ultimately paid out of investors' pockets, the average fund investor is overpaying at least 4.25 cents for every share of stock that his or her fund manager buys.
- Officially, that 4.25 cent overpayment is supposed to pay for "investment research" from the brokers who provide trade execution. In reality, the overpayment has become a way for many fund managers to enhance their already-substantial income. In some cases, for example, a stock broker will actually write a check to the fund manager, equal to (say) 1 cent of the "extra commissions" agreed to by the fund manager. In other cases, "soft-dollar converters" will promise to pay (say) $1,000 of the fund manager's expenses for every $1,600 of commissions directed to that broker. And remember, these rebates are almost never specifically disclosed, and commission rebates almost never find their way into a fund's expense ratio.
- One major soft-dollar converter recently had bill-paying arrangements with more than 1,200 product and service providers, including telephone companies, newspaper and magazine publishers, computer manufacturers, accounting firms, professional organizations, and even The Standard Club of Chicago, described as "a private retreat of luxury and tranquility...home to Chicago's fashionable society and the business elite for over 125 years."
- In other words, if your mutual fund uses this soft-dollar converter, your fund manager can agree to pay stock commissions of (say) $160,000, and the converter can then be directed to pay $100,000 worth of your fund manager's office expenses, such as phone bills, newspaper subscriptions, computer purchases, accounting fees, professional dues, and even club memberships. In some cases, your fund manager will try to classify these expenses as research-related. In other cases, the manager won't even try.
- In the meantime, your fund manager is also collecting its regular, fully-disclosed management fee. To the extent that soft dollars are used to pay for expenses that managers must otherwise incur, just to be in business, the regular management fee becomes pure profit.

Soft-dollar arrangements should be banned, period.....If a fund manager wants to spend money on something, that cost should come out of the management fee, or otherwise be reflected in the fund's expense ratio.

OK, so a total ban isn't going to happen.

At the very least, then, mutual fund managers should be required to disclose the amount of soft-dollar payments they receive, item by item.....Even better, soft-dollar payments should be added to each fund's official expense ratio (this is sometimes referred to as "grossing-up" the expense ratio to reflect soft-dollar payments).....It's also time for the SEC to go back to the pre-1986 rules, under which fund managers couldn't use soft dollars to buy anything that was "readily and customarily available and offered to the general public on a commercial basis" -- for example, newspaper subscriptions, Bloomberg terminals, computer equipment, etc.....If fund managers need or want that kind of stuff, they should pay cash out of their own pockets, just like everyone else.....Finally, managers should be required to spell out all soft-dollar arrangements in detail, in writing.....Fund investors should be required to approve all soft-dollar plans at inception, and periodically thereafter.

As you've probably heard by now, securities regulators have managed to squeeze $1.4 billion in damages out of 10 large investment banks.....The money is supposed to atone for the banks' fraudulent research and stock pumping during the late 1990s tech boom, and about $400 million of the settlement will go to compensate investors who suffered losses due to the banks' malfeasance.....Individuals will be entitled to collect from the settlement distribution fund, but the status of mutual funds is still murky.....On the one hand, funds clearly lost money in stocks that were inflated by bad research and, ultimately, it was the individual investors in those funds who suffered the losses.....But it also seems inappropriate to compensate funds for this kind of loss, even if that money will ultimately flow to individuals, since funds are run by professional analysts and managers who (presumably) should have known better..... As things stand now, it appears that funds will be allowed to apply for restitution, and the administrators of the settlement fund will decide how much (if anything) the funds will receive.

Undeterred by unseemliness, and obviously beyond embarrassment, Janus is one of the first major fund companies to announce that it will apply for restitution from the settlement distribution fund..... Janus has always made a big deal about the quality of its in-house research, as well as the brilliance of its in-house analysts and managers.....Somewhere along the line, Janus will probably have to explain how and why its talented analysts were led so badly astray by mere investment-bank research.

Wait! The explanation has already begun!.....A document recently obtained by FundAlarm appears to be a copy of the application that Janus has filed with the settlement fund administrator, seeking to recover money that the firm lost due to bad third-party research.....According to the application, Janus is seeking restitution of $500 million, which is more than the entire settlement fund.....But that's not the only thing that caught our eye.....This is a tough application, and it won't be easy for Janus (or any other fund manager) to grab a piece of the restitution pie:

Are some money managers too big to be subject to U.S. securities laws? That question arises in the wake of the settlement, discussed above, in which investment bankers agreed to cough up $1.4 billion to compensate for their bum research.....Technically, the settlement took the form of an injunction, in which each firm was enjoined "from violating the statutes and rules that it is alleged to have violated".....Several of the fraudulent firms (e.g., Merrill Lynch, Morgan Stanley, and Goldman Sachs) have mutual fund arms that should have been shut down by the settlement, specifically by Section 9(a) of the Investment Company Act of 1940, which provides that "a company [of which] any affiliated person of which" is enjoined from engaging in certain practices related to the sale of securities cannot act as an investment adviser -- in other words, if an affiliate of (say) Goldman's mutual fund company is enjoined from engaging in certain acts -- which is exactly what happened -- Goldman is also enjoined from acting as a mutual fund manager.....So why are Goldman and the others still running mutual funds?.....As part of the settlement, the investment banks demanded (and the SEC granted) an exception to Section 9(a) of the Investment Company Act, which allows the malefactors to continue in the fund business.....Like we said: If you're big enough, the securities laws don't necessarily apply.
"The Wall Street Settlement's Big Exemption," Ari Weinberg, forbes.com, May 5, 2003

The Investment Company Institute fights back:

ICI Chairman
Paul Haaga (left)

The Investment Company Institute, the big mutual fund trade association, recently held its annual meeting, and ICI Chairman Paul Haaga was feeling feisty.....According to Haaga (quoted in an article by Jonathan Burton of CBS. MarketWatch.com), it's no more Mr. Nice Guy for the fund industry:

"We've acted as though accepting everybody's criticism was part and parcel of being responsible...Some criticism is appropriate, but when it isn't we're going to push back...Some regulation [also] is appropriate, but when it isn't we're [also] going to push back. I just want to make sure...that people aren't using us as scapegoats. We're not a punching bag"

To which we reply: Yes, Mr. Haaga, we know what you mean. Every out-of-touch regime feels the same way.

In his official meeting remarks, Haaga continued with his pugnacious whining:

"When criticism is unfair, uninformed, or unbalanced, or when critics are motivated more by desire to sell publications or competing products, or to gain publicity or political advantage - they become too easy for us to ignore and we lose an important opportunity to listen and improve. To paraphrase a familiar analogy - they become watchdogs whose bark we don't hear anymore."

To which we reply: Yes, Mr. Haaga, we understand your discomfort. It's called "free speech" and "capitalism".

Briefly noted:

"A fund that has virtually nothing going for it except for the fact that it keeps on going": That's how columnist Chuck Jaffe recently described Shepherd Large Cap Growth.....This fund was a sad loser under its previous name (Dominion Insight Growth), and current manager Paul Dietrich, who bought the fund in 1999 (when stock-picking seemed easy), has continued the losing tradition.....It's interesting to note that when Dietrich bought Shepherd Large Cap Growth, he was apparently planning a family of funds (Cowherd? Goatherd?), and he was especially interested in acquiring the Ameritor (formerly Steadman) funds, which are probably the worst funds ever to stain the American financial markets.....It's also interesting to note that Shepherd Large Cap Growth, like the Ameritor funds, espouses a "pro-family," "values-based" approach to investing, and the fund screens out "industries and activities like abortion, pornography, gambling, alcohol and tobacco production".....It never ceases to amaze us how folks who are so zealous about protecting investors from external vices fail to protect their investors from the one danger over which they have total control: Inept (verging on incompetent) money management.....If funds like this really cared about protecting investors, they would stop worrying about threats posed by other companies, and simply shut themselves down.
"Lousy funds don't get better with time," Chuck Jaffe, cbs.marketwatch.com, May 16, 2003
Speaking of loser funds, Jacob Internet has recently been on something of a hot streak, and in mid-May it was the best-performing stock fund in the U.S. over the preceding 12 months (+42.9%).....That's a nice return, if you purchased this fund 12 months ago.....But gains like this only highlight the massive hole that losing funds dig for their long-term investors.....If you purchased Jacob Internet when it was first offered (December 1999), you will have to wait until the fund doubles from its May 2003 level, then doubles again, then doubles again, then increases about 15% -- all before you get back to your original investment.
Rep. Paul Ryan (R.,Wis) has introduced a bill that would allow mutual fund investors to defer paying tax on reinvested capital-gain dividends until they sell the underlying fund shares.....Rep Jim Saxton (R., N.J.) has introduced a similar bill several times over the past few years, without success, but Ryan's bill is different in two important ways: It would allow deferral of all reinvested capital-gain dividends, instead of Saxton's relatively small dollar limits, and Ryan's bill is being introduced in the House Ways and Means Committee, which gives it a better chance of being taken seriously.....Prospects for passage?.....Ryan's bill has a lot of supporters, including Rep. Saxton and the Investment Company Institute.....But it's still too early to say how the bill will fare, or if Congress has any interest in additional tax-cutting.

There's something wrong here:

From the May 2003 issue of FundAlarm:

"Principal-protected funds are for suckers, and now even the NASD (almost) says so.....In an alert posted on the its Web site, the NASD warns that this too-good-be-true investment is, well, too good to be true."

From the May 2003 issue of OnWallStreet.com:

"...the third best-selling fund last January was ING's Principal Protection Fund V, which took in $662 million. As [OnWallStreet] goes to press, six new PPFs are either in their offering period or have completed it...Not surprisingly, one of the new funds is an ING product -- INP Principal Protection Fund VI, which closed to investors on April 15..."We've been offering principal protection funds on a quarterly basis since October of 2001, and as long as there is public demand, we'll continue to do so," says Mary Ann Fernandez, senior vice president and portfolio strategist for ING's $6 billion [!] in PPF assets."

There's also something wrong here:

From an interview with Robert Turner, manager of Vanguard Growth Equity, which appeared on the Vanguard Web site:

"...although our financial services stocks haven't performed as well as we would have liked, we don't focus on short-term performance."

...and then, several lines later...

"Because we buy and sell stocks at a relatively high rate, the fund is most suitable for a tax-advantaged account, such as an IRA."
Tom Shilacci, Champion of Corporate Democracy: Janus Capital Group, the company that runs the Janus funds, recently held its first annual shareholder meeting.....Although Janus shares dropped about a third of their value in the past year, corporate earnings were off 72 percent, and don't even ask how much money Janus fund investors have lost, only one attendee at the meeting even bothered to question the executives who've been running Janus.....The aforementioned Mr. Shilacci, a former Janus employee who was laid off in 2001, rose and asked if he could have his job back.
"Janus' incentive plan for top execs approved," Aldo Svaldi, denverpost.com, May 9, 2003
A press release headline:

Among the queries reportedly used to test Strong's new voice recognition system:

"Why is your Multi Cap Value fund performing so poorly?"

"What's the problem with your Balanced fund?"

"Hey, will you do me a favor, and stick your Advisor Mid Cap Growth fund where the sun don't shine?"
Ed Haldeman and Steve Oristaglio are the dynamic duo now responsible for making Putnam straighten up and fly right.....But what to do, what to do?.....In a burst of symbolism over substance, Haldeman and Oristaglio last fall decided to relocate their offices from the plush executive suite to the less-exclusive 10th floor digs, where Putnam's fund managers and analysts toil.....The investment staff wasn't thrilled with the move and, to make matters worse, it turns out that Haldeman and Oristaglio were a little loud.....Shortly after they moved in, workmen showed up to soundproof their offices.
"Top Brass for Putnam's Mutual Funds Group Move in with Investment Staff," Beth Healy, The Boston Globe, May 1, 2003
Duncan Evered (manager of AXP Equity Select) and Paul Rokosz (manager of AXP Strategy Aggressive Growth) have just moved from Minneapolis to San Diego, California, where they will share an office with Gordon Fines, manager of AXP New Dimensions.....Investor's Business Daily reports that the three men "run their portfolios according to what they call the 'San Diego philosophy.' Developed by Fines over the years, it involves pruning losers from the portfolio and letting winners run. They look for companies with earnings and revenue growth and rising profit".....Previously, this had been known as the "Unbelievably simplistic" philosophy.

Here's an item we ran in the April 2002 Highlights and Commentary:

Ned Johnson is the quiet, low-profile billionaire who runs the Fidelity fund family, but it appears that even Johnson can get riled by a home contractor......Over four days last month, in a Maine courtroom, Johnson duked it out with a contractor who also happened to be Johnson's friend and tennis buddy for the past 30 years.....At stake was 0.00116% of Johnson's net worth ($50,000), which the contractor claimed was his fee for supervising construction of Johnson's home workshop, and which Johnson insisted he didn't owe.....According to the lawsuit, the contractor began overseeing construction of the workshop in November 1999, but the financial arrangements were never put down in writing....."Trust the Great Oracle," Johnson reportedly assured his friend......Johnson is also known as a modest man, which is probably why he didn't refer to himself as God.

Well, Johnson hasn't heard the last of his friend and contractor, whose name is Richard Larson.....Larson has written an expose of Johnson, called Surviving Ned Johnson: How Fidelity CEO and Chairman Ned Johnson Traded His Faithful Friend for a Few Dollars, and Larson plans to self-publish his book on the Internet.....But wait: Larson says that he'll give up the rights to his book, and even turn it into a flattering portrait, if Johnson would be so kind as to pay him $3 million.....Through his attorney, Johnson claims that Larson is violating federal extortion statutes, and that the manuscript libels Johnson.....Sounds like both of them need to be hosed down.
"Fidelity Chairman Is Roiled by Book Written by Disgruntled Ex-Employee," John Hechinger, The Wall Street Journal, May 22, 2003

"They don't talk to me. There is no communication. It is fine with me".....That's how John Bogle sums up his current, sad relationship with Vanguard, the company that he founded.
* "Bogle in exile," Steve Bailey, boston.com, May 9, 2003
Ralph Wanger is the only mutual fund manager associated with squirrels, and now Wanger has decided to pack his nuts and go home.....Effective September 30, Wanger will relinquish his day-to-day responsibilities as manager of Liberty Acorn, and experienced co-manager Chuck McQuaid will take over.....Joining Wanger in retirement is his wife, Leah Zell, who will step down as manager of Acorn International and turn the reins over to co-managers Zachary Egan and Louis Mendes, about whom it can genuinely be asked, "Who?".....As you may recall, Wanger and Zell sold out to Liberty in September 2000, and we all thought they were contractually bound to at least five more years of service.....Now, it turns out that both had negotiated an early-escape clause, which is what they are invoking to obtain their freedom.....Wanger and Zell will remain as one-day-a-week consultants for the next couple of years (meaningless), while Wanger will continue to serve as a fund director and write his "Squirrel Chatter" column.
Last month, we reported a rumor that Scott Schoelzel, manager of Janus Twenty, was planning to take off the entire month of June.....Schoelzel has informed us that the rumor is not true.
Delaware Investments has announced the launch of its BOB funds, which stands for "Best of Breed" (as in, "BOB Large Cap Growth").....Not wanting to be left out of the man-named fund market, Wasatch is considering a line of GUS funds ("Great Undiscovered Stocks"), while Baron has high hopes for its WES funds ("We Evade Statutes").
Want to see a man who really enjoys back-end loads? Click on this link, and a Yahoo! page will appear in the pop-up window.....Be sure to check out Mr. Stirna's former occupation.