Conflict of Interest Term Paper

Pages: 11 (3466 words)  ·  Bibliography Sources: ≈ 11  ·  File: .docx  ·  Level: College Senior  ·  Topic: Economics

SAMPLE EXCERPT . . .
This procedure updates the price of securities to reflect information that emerges after the market closes. Unfortunately, most firms do not actually use fair-value pricing to eliminate opportunities for arbitrage. This leaves the funds vulnerable to market timers who seek to trade on, or arbitrage, stale prices, by buying fund shares at outdated prices and selling them a day or two later. A few firms actually do use delayed or confirmed exchanges to discourage speculators, forcing them to wait up to seven days to move money from one fund to another. Here again, though, very few firms actually enforce this sort of a policy. Another widespread trading abuse is late trading, where fund shares are bought and sold after the markets close. This practice is not only unethical, it is illegal (Hume, 2003).

Is the fund the victim of market timing? One way to spot a fund at risk of being the target of market timers is to calculate its redemption rate, which reveals how long shareholders hang onto their stake in the fund (Tergesen, 2004). This information is available in the fund's most recent annual or semiannual report under "Notes to Financial Statements." Dividing the dollar value of the fund's redemptions (shares reacquired) by its average assets during the same period and converting the number to a percentage (multiply by 100) reveals the redemption rate. A redemption rate of 100%, for instance, is the equivalent of every investor turning over their shares in the course of the year. A high redemption rate does not automatically mean that there is market timing going on, but it is a definite red flag.Buy full Download Microsoft Word File paper
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Does the mutual fund firm require employees to keep the shares they own in their own funds for a minimum holding period, or even to invest in their own funds at all? While mutual fund companies heavily advertise the virtues of long-term investing, it appears that fund managers do not come close to practicing what they preach (Zweig, 2004). Taking this a step further, most firms do not prohibit employees from investing outside their own company's funds - when fund managers have that brilliant investment idea, it does not necessarily stay inside their own fund, or even company. Until the SEC mandates better disclosure, it is impossible to discern how much money fund managers have put into the funds they run. Another issue here is whether the firm allows its fund managers and/or principal underwriters to conduct short-term trading. The answer to look for is no.

Are brokers being paid an incentive to push in-house funds? More than one brokerage house has been accused of cheating mutual fund investors out of several million dollars through high-pressure tactics (Weinberg & Lambert, 2003).

Does the firm have an official code of ethics? The fund and investment advisers, as well as the principal underwriters, should have a strictly enforced code of ethics to prevent abusive transaction practices (Coffin, 2004).

Director Independence

There is a notable lack of independence among the members of the boards of directors who are supposed to be making sure mutual funds are run in the best interest of the investors. The watchdog role of a fund's board of directors theoretically includes not only watching the big picture, but also the minutiae of the funds' service contracts, operations and investment policies. These board members should be free of potential conflicts of interest in order to play the biggest role possible in making sure the best interests of their funds' shareholders are served. Some of the critical areas to be analyzed here include:

How many board members are independent? It is important to know how many board members are relatives of the fund managers, are former executives of the management company or are collecting consulting fees from the firm (Zweig, 2004). The SEC currently provides a glaring loophole, allowing even the former chairman of a fund management firm to be considered independent only two years after leaving the company.

How are the board members compensated and are they required to make any minimum investment in the funds they oversee? Only two fund families in the top 100 pay directors with fund shares instead of cash, while only eight require directors to invest a minimum amount in the funds they oversee (Zweig, 2004). Requiring that directors be paid with shares and requiring them to invest their director's fees in their funds along with the general public might help them to understand how investors expect to be treated. Instead of behaving as though they are employees of the management company, directors might actually think like owners of the funds they oversee.

Do board members meet without fund management being present? Directors' independence is vastly enhanced when separate meetings take place for consideration of contracts, fee increases and claims against either advisers or affiliates.

Does is take a majority of independent directors to nominate and elect new independent directors? Control of the nominating process dispels any notion that directors are handpicked by the manager and not truly independent.

Transparency of Fees and Expenses

The job that has been done of supervising fees and expenses for Mutual Funds is appallingly bad. The average net profit margin at publicly held mutual fund firms was 18.8% in 2002, compared to a 14.9% margin for the financial services industry overall and 3% for the S&P 500 (Weinberg & Lambert, 2003). In comparison, the average actively managed equity fund has returned only 5.3% annually over the past 10 years. The mutual bund business grew 71 times over in the two decades through 1999, but costs as a percentage of assets rose by 29%. This industry simply tossed economies of scale out the window, charging more per dollar invested as fund assets have grown.

The critical cost elements which affect the performance of a mutual fund, are generally not fully disclosed (or sometimes disclosed at all) to investors, but are necessary to a full analysis of fund performance include the following:

Is there a fund breakpoint? At some point, investor expenses should be reduced by virtue of the fund growing larger and more efficient (Zweig, 2004). Economies of scale...remember them?

What are the soft-dollar numbers and are they included in management fees? High fees are only part of the cost picture. Mutual funds also run up trading charges averaging five cents per share, which is five times the rate paid by retail investors to an online discounter. The funds paid these fees because the currency was so-called soft dollars. Soft dollars were devised as a way for funds to compensate brokerages for securities analysis by sending commission business their way (Weinberg & Lambert, 2003). Today, soft dollars are a $1 billion-a-year business. They are fundamentally a rebate on commissions in exchange for directing trades to the brokerage firms (Anand, 2003). Fund managers have been accused of using soft-dollar kickbacks to pay for a range of items that have nothing to do with the fund they are charged with managing, including rent, interior decorating and concert tickets. Funds also use their commission dollars to reward brokers for bringing in new clients. The abuse has been so bad that the Financial Services Authority, the British equivalent to the SEC, called for banning soft dollars outright early in 2003 (Weinberg & Lambert, 2003).

What is the quantity discount on sales commissions for fund investors and is this being granted automatically to qualifying investors? The industry has often been guilty of failing to grant the discounts that customers are promised (Weinberg & Lambert 2003). A study of 43 brokerages found that nearly a third of fund investors eligible for quantity discounts have not been receiving them - the average discount missed was $364.

What does the firm include in its annual expense ratio? Most funds only include the costs of investment management, distribution and marketing expenses, and administrative operating expenses as a percentage of net assets in the expense ratio, but not trading commissions (Maiello, 2003). Note: Even though the average stock price dropped to $30 in the 3Q of 2002 from around $50 in the 3Q of 1997, commission per share rose from 12 to 16 basis points, and the total brokerage cost, including market impact, rose to 147 basis points from 101 (Anand, 2003).

What are the true transaction costs? These include commissions, which can be measured directly, as well as spreads, market impacts and opportunity costs, which are implicit costs (Hume, 2003). Spreads are the difference between the bid and the asked price and may include both imputed commission on the trade and any market impact costs associated with it. Market impact costs are incurred when the price of a security changes as a result of the effort to purchase or sell it. Opportunity costs are the costs of trades that are missed.

What is the effect of daily decisions to trade? This reflects the combined effect of transaction costs and gains and losses from short-term trading (Hume, 2003). It reflects the… [END OF PREVIEW] . . . READ MORE

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