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The Mutual Fund Scandal: Unfair Fight

Nov 30, 2003 | NEWSWEEK On Wall Street, there are big, well-connected fish. And then there are regular, little investors, who are the fish food. Exhibit A? The case of fund manager Gary Pilgrim, perhaps the most startling example of alleged abuse of investors to come out of the mutual-fund scandal. It's a tale of how insiders can grow fat from their stake in a fund even as regular investors are being stripped to the bone.

IT TURNS OUT that Pilgrim made rich profits from investing in his PBHG Growth Fund while shareholders lost big. PBHG Growth dropped 65 percent from March of 2000 through November of 2001, the period covered in suits filed by New York Attorney General Eliot Spitzer and the Securities and Exchange Commission. That's a loss of 45 percent a year. But during that same period, according to NEWSWEEK's calculations based on information in the suits, Pilgrim made 49 percent a year on his stake in PBHG Growth. His profit: $3.9 million.

How can this be? Unlike regular sucker investors, Pilgrim owned his stake by investing through an outsider: a hedge fund called Appalachian Trail. Appalachian profited by betting against Growth. NEWSWEEK has learned that Appalachian, which regulators say bought and sold Growth a total of 240 times during this period, made most or all of its profit by betting that the value of the fund's stock portfolio would fall. Regular investors, by contrast, profited only if Growth's investments increased in value.

Pilgrim, as the fund's manager, had a legal and moral fiduciary obligation to look after his investors' money and place their interests ahead of his own. But instead, he seems to have profited from his investors' misfortune. It's as if a captain ran his ship into an iceberg, however inadvertently, then jumped into a private lifeboat and collected on his passengers' life-insurance policies. Pilgrim's lawyer had no comment on the regulators' suits or on NEWSWEEK's analysis. His defense, people involved in the case say, will apparently be that he was a passive investor in Appalachian and didn't help it bet against Growth.

The Pilgrim story is part of the almost-daily revelations about mutual-fund misdeeds that are driving home a message we can no longer ignore: even when we hire professional managers to look after our money and give us a diversified portfolio, we can get eaten alive. We thought mutual funds were boring but safe, compared with individual stocks. Now we're finding out that many funds weren't trustworthy.

Hardly a comforting thought, considering that, with the decline in traditional pension plans and the increasingly troubled status of Social Security, most of us have no choice but to use mutual funds to help us retire. Funds are also the only realistic option for saving for our kids' college education. "Mutual funds have become the bank of necessity for middle Americans," says Massachusetts Secretary of State William Galvin. "But what they're discovering is that the mutual funds have screwed them."

We knew mutual funds weren't cheap, once you added up all their fees and expenses that on average chew up a quarter of your return. But it never occurred to us that many of them were corrupt. We now see that in at least some cases (Janus and Bank of America, among others), fund companies let outsiders skim their funds with techniques like so-called market timing in return for other, more lucrative business.

For an example of how market timing works, let's revisit Appalachian Trail and see how it profited from investing in money-losing PBHG Growth. It didn't simply buy and sell the fund it used so-called derivatives to make its money and limit its risk. Whenever Appalachian bought Growth shares, it also bought securities from Wall Street investment houses that mimicked the fund's portfolio. The investment houses collected from Appalachian if this "shadow portfolio" rose in value; Appalachian collected if the shadow portfolio fell. Appalachian's lawyers declined to comment.

For reasons that aren't clear, the shadow portfolio fell more quickly than PBHG Growth's asset value did during some down days in the stock market. Thus, Appalachian made more money on its shadow-portfolio bet than it lost on its Growth shares. So Appalachian would sell both its fund shares and its shadow portfolio and pocket a profit.

It made a total of 120 buy-sell round trips in a mere 21 months, according to the suits. That's far more than the limit of four round trips a year that PBHG Growth imposed on other investors. But what if PBHG Growth's portfolio rose, as it did almost half the time? In that case, the profits on Appalachian's fund shares offset the loss on the shadow portfolio. So heads, Appalachian won. Tails, it didn't lose. In all, according to the SEC, Appalachian made $13 million from its trades in Growth.

Transactions like this explain how hedge funds unregulated investment pools have managed to show steady annual returns of more than 20 percent by "timing" mutual funds during years when the stock market was falling sharply. Of course, "timing'' is really just a euphemism for the well-connected big fish skimming profits at the expense of small-fry mutual-fund investors. Hedge funds have been involved in most of the allegations of wrong-doing, which first surfaced in September when New York's Spitzer brought a case against four fund companies and a big hedge fund, Canary Capital. Galvin, the Massachusetts secretary of state, says, "Letting hedge funds buy shares in mutual funds is like putting a shark in a goldfish tank."

The SEC, which is supposed to regulate mutual funds, has been scrambling to catch up with Spitzer and Galvin, and has vowed changes. But the SEC has a big credibility gap. It didn't pick up on clear signals, such as academic literature discussing the profits that investors could make exploiting flaws in mutual-fund pricing, that something was amiss in fund-land. Not to mention the fact that many Wall Street trading desks notoriously gossipy places had to know that the Appalachians of the world were messing with mutual funds. Had a source not perched at Spitzer's door and chirped about Canary Capital, this scandal might never have surfaced.

There are now all sorts of bills and SEC proposals designed to reassure Americans that someone will look after their mutual-fund money. But these proposed safeguards are long on legalisms, and will be difficult to implement. Take the idea that mutual funds should have independent directors looking after shareholders' interests. There are more than 8,000 funds.

Can you imagine finding five directors 40,000 in all per fund? Or how much this will cost in legal bills and consultants' fees, all of which would come from fund shareholders? Spitzer has a much simpler idea. First, prohibit hedge funds from investing in mutual funds, a no-brainer. Second, don't let a company run both hedge funds and mutual funds. And third, forget about finding thousands of new directors and just hold fund managers to their existing fiduciary obligations. "The rules don't need to be changed," he said. "They need to be enforced."

The government could make one other simple fix if it really wants to look out for the average investor's best interests: limit the proportion of a 401(k) plan that employees can invest in their company's stock. That would limit their upside, but also prevent them from being wiped out. It would bar workers from the investment equivalent of drunken driving. We've all heard of Enron victims whose 401(k)s vanished when Enron vaporized. But two thirds of what these unfortunates lost was their own mistake.

They had to hold some Enron stock, because that's what the company put into their 401(k) accounts as a match: 50 cents of Enron stock for each dollar. But employees didn't have to invest their own money in Enron stock, too. Many did, and lost everything. The best investor in Congress, Sen. Jon Corzine, a New Jersey Democrat, formerly head of Goldman Sachs, tried to fix this problem by imposing a 20 percent limit on employer stock in 401(k)s. But Corzine's proposal ran into a brick wall in Congress for limiting investors' freedom of choice. "I couldn't get past first base," he says.

Look, professional investors are always going to do better than amateurs just as fishing pros generally catch lots more than recreational anglers do. But if we adopt a few new rules and enforce the ones we have, average people will have a fighting chance, instead of being fed to predators.

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