Chuck Jaffe: Small payback belies big impact of 2003 mutual-funds scandal

Five years ago, the mutual- fund world was rocked by the biggest scandal in its 80-year history.

Fund companies gave some customers trading privileges that weren't open to everyone; those special interests — notably some hedge funds — engaged in rapid trading that netted quick profits at the expense of the average shareholder.

Headlines called it a "market-timing scandal," a misnomer since there's nothing illegal about trying to time the market. The problem wasn't even so much the quick-fire trades as it was the special privileges that let traders play games that the ordinary shareholder couldn't engage in and actually paid for.

Now shareholders in scandal-tainted funds are starting to receive payments to compensate for their losses. The SEC just sent checks worth a total of $40 million to 600,000 Putnam investors. Another $18 million was distributed to some 325,000 Janus shareholders.

That's about 66 bucks per affected Putnam account — it's about $55 per Janus shareholder — and only really big shareholders get even close to that average. Over the next six months, an additional $110 million will go to Putnam shareholders. Janus investors will see $80 million-plus in distributions. The fund firms — and there are many others who paid fines for similar charges — admitted no wrongdoing, but agreed to the repayment deals. Virtually all of the cases have gotten to where payouts are ready to go to shareholders in funds where rapid trading was allowed.

The scandals centered on "stale-price arbitrage" in international funds. Knowing that European markets closed hours before the domestic exchanges, speculators would look for days when the broad market rose sharply.

Just before 4 p.m., the speculator would buy shares in funds with big international exposure, knowing that the foreign markets were already closed for the night; the bet was that the big day in America would trigger an equally big response abroad the next day.

Had the foreign markets already been open, the market would have priced that optimism in; with the foreign markets closed, the prices were stale, creating a chance for the speculator to grab a quick profit.

The ordinary shareholder was paying the trading costs for the money moving in and out; Spitzer said funds would not put the new cash from the arbitrageur to work for days, thereby diluting any gains the fund made from the foreign exposure.

Industry supporters will use the small-dollar repayments to shareholders to say that the scandals were overblown. They weren't, because they showed a weakness in the system — and in management's character — that needed to be fixed before it was exploited further.

Investors should focus more on performance than backroom shenanigans but the legacy of the small-dollar/big-headline scandal is that it probably saved the industry from getting into worse, bigger problems.

Chuck Jaffe is senior columnist at MarketWatch. He can be reached at cjaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.