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The miles file

What are British savers to make of the unfolding scandal in mutual funds on the other side of the Atlantic?

Is this simply yet another political platform for the ambitions of Eliot Spitzer, the New York attorney general? Or is the heart of popular capitalism in the US truly corrupt? Since Mr Spitzer announced an investigation into a little-known hedge fund dubbed Canary at the beginning of September, the revelations have come thick and fast.

The probe is gathering momentum at a frightening pace and threatens to drag in virtually every big name in mutual funds.

Putnam Investments has been cast as one of the main culprits in this sprawling scandal. As a consequence, the firm, one of the biggest players in mutual funds, has lost $12bn of fund mandates -a number that appears to rise by the day – and has been forced to part company with its long-serving chief.

British companies have so far avoided any involvement, although Amvescap, the parent of Invesco Perpetual, has become embroiled. Its share price has plummeted since news broke that Mr Spitzer&#39s associates were considering filing charges against the company, which has its headquarters in Atlanta, Georgia.

The attorney general&#39s investigation has sparked a similar examination by the Securities and Exchange Commission, the main financial regulator. Between them, the two groups seem intent on tearing a strip off the mutual fund industry and securing recompense for the 95 million people who gain their exposure to equities through these funds.

For anyone not familiar with the story, there are two charges of wrongdoing.

First, mutual funds conspired to allow hedge funds to make easy money by allowing them to deal at “stale” prices. Such a market-timing strategy is not illegal but it is regarded as unethical.

The second, and less common, charge is that hedge funds have been permitted to deal after hours. This is illegal for obvious reasons.

Wall Street watchers are beginning to claim that the mutual fund scandal could dwarf the alleged corruption among investment bank analysts during the dotcom boom because such practices have been going on for years.

The truth is that market-timing hedge funds were picking away at mutual funds throughout the 1990s but no one was too bothered by their activities because there was plenty of largesse for everyone. However, even if you plough through the acres of news copy dedicated to the story in the American press, it is difficult to pinpoint how mutual fund customers have suffered. And if so, how much money they have lost. There are no big numbers except for the size of the mutual fund industry, which is valued at $7,000bn.

This is not a victimless crime. It is the business of hedge funds to exploit the mispricings and mistakes of the rest of the investment industry – and that means at ordinary savers&#39 expense.

As one hedge fund manager summed up the position for me this week, hedge funds are a parasite on the back of an elephant.

As far as I can fathom, savers lose out because the value of their holdings is depressed by the activities of hedge funds.

The profit that the hedge fund manager takes could have been attributed to the holdings of the long-term investors. Or to use the lingo of organised crime, there has been a massive “skimming off” from mutual funds.

The only serious attempt to calculate the damage that I have seen is work by the Stanford Graduate School of Business. The boffins there reckon that mutual fund customers who own international portfolios have lost 1.1 per cent of their total assets during 2001 to market-timers and a mere 0.05 per cent to late trading.

This is clearly rich-picking for the hedge funds but do not forget that 1 per cent of $7 trillion would be $70bn if the activity was spread across the entire industry – it does not sound much for each investor, notwithstanding the low forecast returns for equities.

A rough consensus suggests that shares will pay about 7 per cent in nominal terms each year. The low impact on personal accounts probably explains in part why the focus of critics has shifted to the fees levied by mutual funds.

As a result of the charges imposed by fund managers and their intermediaries, the average return to mutual fund investors between 1984 and 2002 was a mere 2.6 per cent, according to calculations by Vanguard, the US investment house.

British companies can sidestep the issue of hedge funds and market-timing but they cannot ignore the corrosive nature of fees – and nor will savers for much longer.

Richard Miles is investment editor at The Times


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