Monday Morning: Fund bigwigs risk it all for small potatoes

Perhaps the most puzzling aspect of the burgeoning mutual fund scandal is that the gains from the market-timing and after-hours-trading activities were relatively small compared with the potential cost of the damage to reputations, and possible criminal sanctions.

Richard E. Strong, chairman of Strong Capital Management Inc. of Menomonee Falls, Wis., is ranked 318th on the Forbes list of the 400 wealthiest Americans, with a net worth of $800 million.

Why would Mr. Strong put at risk his reputation – and that of the firm he started and built into a powerhouse – by market timing in his firm’s mutual funds for a reported gain of about $600,000, as has been alleged?

Terrence Odean, associate professor of finance at the Haas School of Business at the University of California at Berkeley, has several theories.

“If you had called me about Martha Stewart, we could have asked the same question: `Why would anyone risk so much for so little?”‘ says Mr. Odean, who specializes in behavioral-finance research. “In Ms. Stewart’s case, it’s more understandable because she was reacting to news.”

Ms. Stewart could have avoided her current problems by responding, when challenged, that “`I heard so-and-so was selling and said “sell” without thinking,”‘ he says. It would have been a natural reaction, and people would have understood, Mr. Odean says.

Like blackjack

It is more difficult to understand the case of Mr. Strong and mutual fund portfolio managers who have been accused of market timing, or others who allegedly allowed hedge funds to trade after hours.

“It’s possible it’s just the challenge of doing it,” Mr. Odean says.

“Rich people try to win at blackjack also. It’s the reward of solving the puzzle or winning the game, even in a small domain,” he adds.

“For some people, there’s also the temptation to try to do the clever thing, and when they do it, they aren’t thinking about the risk. They aren’t thinking: `I’m risking the firm, but I’m pretty clever, and it works.’ They just don’t think further; they don’t integrate the immediate situation into the big picture.”

Thomas Manheim, founder of The Love of Money Inc. in Solana Beach, Calif., says that in situations such as Mr. Strong’s, “in general, there is a certain amount of power and status that goes with being bright enough to beat the market. In their group of peers, there is a gray area because they have so much power that they lose sight of what is real and what is not.”

matching wits

“This becomes a game of stimulation and excitement,” says Mr. Manheim, who has a master’s degree in psychology, is working toward a doctorate, and terms himself a “money therapist.”

“Let’s face it,” he says, “there are probably not a lot of other things they have to worry about. This is a way to consciously ramp it up and to find stimulation: their minds against the market.”

For some mutual fund portfolio managers, market timing may be a way to match wits against other portfolio managers.

Also, “maybe there’s an element of fear, of wanting to get ahead because you don’t know how long the market is going to hold up, and this is a way to protect themselves so they’ll be protected in the future,” Mr. Manheim adds. “They see money as security.”

He says that for Mr. Strong, it was likely a game of trying to beat the system.

“I don’t think he’s a bad person,” Mr. Manheim says. “I don’t think he was trying to hurt anyone.”

More likely, Mr. Manheim adds, Mr. Strong just lost track of the rules of the game. “You can become so powerful … that unless society steps in occasionally and says `not allowed,’ you think you can do anything; you lose sight of right and wrong.”

Mr. Odean says he tells his ethics students at the business school that the test of whether something is ethical is to ask the question: “Would you be embarrassed to see it on the front page of the newspaper?”

That is a question a lot of businesspeople have forgotten to ask themselves in the past few years. We thought mutual fund industry executives were different and that they still remembered to ask it.

We were wrong. Some forgot, and they have given themselves – and the industry – a black eye.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.