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'MUTUALLY' CONVENIENT MODUS VIVENDI
Some might say that the regulators are on the rampage in the U.S; yet again! But what we are now seeing is a massive shake-up of the financial architecture; especially in the U.S. For instance, the New York Stock Exchange (NYSE)'s Board of Directors was revamped and is now headed by Walter Reed, ex-Chairman Citibank and contains eminent and seemingly unimpeachable names. This followed the excessive compensation package that the previous incumbent got sanctioned for himself that came out of the regulatory wash! Or those arising earlier from the Enron, Tycos and other corporate fiascos. Now, it seems to be the turn of the mutual fund industry from Putnam to Morgan Stanley to Merrill Lynch, who are all coming under surveillance! First, their brokerages and research came under scrutiny and then some wrongdoings; leading to some penalties being levied. Now the search lights are focused not just by the Securities & Exchange Commission (SEC) but also by New York's own very aggressive public prosecutor on the sins of commission and omissions! SEC's chairman, William Donaldson told the U.S. Congress that SEC will create a new Office of Risk Assessment to improve its ability to get early warnings of market problems like the 'trading' scandals. These are essentially trades in mutual fund shares and for this, SEC is now setting up a daily deadline. Such trading aggregates to US$ 7 trillion and there have been some questionable market practices. In fact, the new fund trading rules are expected to prohibit trades of fund shares after they are priced for the day - typically at about 4 o'clock in the evening.
This cut off time, Donaldson said, would effectively eliminate the potential for late trading through intermediaries that sell mutual fund shares. SEC will also consider requiring mutual funds to have specific procedures for complying with a stringent set of policies on 'market timing'. This is 'rapid trading of fund shares to profit from out of date prices'; as it was explained, by him.
Morgan Stanley is a fine institutional name and a blue chip to the core. For them to have allegedly 'accepted payments for giving preference to chosen brokers and groups of funds that nudged investors towards certain classes of mutual fund shares', is simply because these were said to have given them higher commission. It is sad that since Barings, all the investment houses of repute are getting mired and sullied in controversies and for the scale of profitability, these scandals are avoidable and wholly unprofitable.
Truly, such practices are also found among institutions globally. Almost three-fourths of all mutual fund purchases are made through brokers, financial intermediaries and financial institutions. Just as the number of such collective investment schemes have grown, so has the trend for mutual fund managers and institutions to pay such intermediaries, liberal commissions for obtaining the so-called 'shelf space'. Some of these are charged off to disclosed fees, specified as a revenue-sharing arrangement. But others are regarded as 'soft commission' and the regulators are naturally concerned that such soft-commission arrangements are not good practices and transparent conduct. Besides, they tend to be at the expense of the investors especially retail. They would naturally like to see a breakdown of these expenses i.e. what is charged, and whether there is an independent oversight of these by say trustees and whether the mutual fund auditors are independent from that of the auditors of the asset management companies etc. Therefore, there ought to be no conflict of interest on any one's part; certainly of the undisclosed variety.
The advisory board or trustees arrangement essentially requires them not to merely 'rubber stamp' what is presented to them, but challenge and scrutinize carefully all matters relating to the mutual funds; in particular such soft commissions, revenue-sharing and related-party transactions. It is believed that in the U.S. itself, such soft commissions could amount to over US$ 2 billion p.a. These are perceived by the general public as 'back-handers' or 'under the table' arrangements. Therefore, not disclosing them in a transparent manner to investors is inviting trouble and damage to credibility. If it is an industry practice, that has to change.
All these can be put down to the greed factor. Few smart or informed investors will grudge reasonable management fees, sales commissions and other expenses that mutual fund organizations need to incur and even reasonable incentives for them to achieve superior results by way of trailer and / or performance fees. But when the chain of intermediaries is long and the brokers slice and eat up pieces of the cake, then what is left is precious little for the investors; who are the raison d'etre, in the first instance, for such a mutual fund or collective investment scheme to be in place.
Without adopting a 'holier than thou' approach, institutions in this region are equally culpable in some respects; e.g. charging high fees. Investors do not mind this and cannot help it as long as the performance is in double digits and the fees are (even) in high single digits. But when there is a prolonged downturn in the equity markets, then the wrenching starts and investors vote with their feet; i.e. exit the mutual funds.
In a large market, such as the U.S., the regulators start to go after the so called 'blue chip' institutions with a vengeance, if only to set examples and collect punitive fines. That again is a swing of the pendulum from one extreme to the other.
Many of these regulators turned a blind eye when the going was good. Neither the customers nor the congressmen were complaining! Now some of the regulators also wish to occupy senior administrative positions and / or the political arena. Some of the public prosecutors, then start to play up to the gallery and vying with each other to "name and shame" institutions (as the British called it a few years back, when they identified insurance companies that indulged in mis-selling pensions and insurance policies).
Ultimately, all these are mis-selling propositions. Surprisingly, self regulations do not seem to have quite worked well. There is a National Association for Securities & Dealers (NASD) in the U.S. but they have not been able to rein in malpractices. That indeed, is a pity because for innovation and markets to grow, robust self-regulation is not only helpful but also necessarily good practices. Ethical conduct alone, in the long run, will have enduring value.
[The author is General Manager of Emirates Bank. However, the views expressed in this article are not necessarily shared by the Bank].
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