SEC probing funds for `portfolio pumping’

Federal regulators are investigating mutual funds to determine whether they are engaging in an illegal practice known as “portfolio pumping.”

Gene Gohlke, associate director of the Securities and Exchange Commission’s office of compliance, inspections and examinations, tells InvestmentNews that the agency has requested trading records from some mutual fund companies as part of a task force investigation into the possibility that funds are engaging in the practice.

Portfolio pumping occurs near the end of a reporting period – month, quarter or year – when managers buy extra shares of stock they already own to drive up the price. The move creates the appearance that the fund is performing better than it really is.

“Certain securities seem to indicate this price pattern at end of reporting periods,” says Mr. Gohlke.

Looking at trading records is “the only way one can determine whether a particular entity has engaged in this type of activity,” he says. “Just looking at net asset values doesn’t tell you anything about whether those funds actually engaged in it.”

Mr. Gohlke would not say how many funds have been asked to produce trading records.

He says the task force, which has been looking at the issue for the past three months, is also trying to determine why any end-of-period trading may have occurred.

“It could be that some mutual fund managers may be aware that the market sort of produces this result. Even though they don’t do any trading at all, they might still have the benefit of that.”

The task force, which is not under any time limits, is looking at “whether that type of activity is occurring in the fund industry, or more broadly among registered investment advisers,” says Mr. Gohlke.

Close attention

Richard Walker, director of the SEC’s division of enforcement, said in a speech to the D.C. Bar Association last month that the agency has yet to bring any cases for portfolio pumping, but “it is something we are paying close attention to.”

Mr. Walker cited a recent case brought against the investment management arm of the Royal Bank of Canada by the Ontario Securities Commission for a similar practice.

Mr. Walker added that he is also concerned about “window dressing” by funds, in which fund advisers buy or sell securities at the end of a reporting period to mislead investors about what assets the fund holds or what investment style the fund follows.

A joint study issued in late October by researchers from the Wharton School at the University of Pennsylvania, the University of Texas in Austin and Goldman Sachs Asset Management is also adding more fuel to the flames surrounding the practice.

An update of an earlier study, the new report focuses on the jump in net asset values in Lipper indexes at the end of performance reporting periods, particularly on the last day of the year.

“What you see is that the [indexes] outperform the S&P 500 significantly on the last day of the quarter, and then they underperform on the first day of the next quarter,” says David Musto, assistant professor of finance at Wharton and one of the study’s authors.

“People are marking up their portfolios. They are making purchases in stocks that they already own in the last minutes of the trading day,” Mr. Musto says.

“There’s an increase of trading volume when you are tracking year-ends, quarter-ends, month-ends, relative to other days. You see that big bump-up in excess trading activity.”

Mr. Musto also says the phenomenon is more pronounced for the top-performing funds.

The researchers did not specify particular funds but sorted them by computer for the top funds in each type of category.

“The top funds show more of this effect,” he says. “They do extra-special well on the last day of the year,” when top funds are fighting it out to be No. 1 in their category, he says.

“The punch line here is that at least some of this effect is due to mutual funds buying shares of stock they already own,” says Mr. Musto.

However, Mr. Musto does not rule out the possibility that some of the heavy end-of-period trading comes from hedge funds, which are unregulated and do not disclose holdings.

sources of abuse

Michael Lipper, chairman of Lipper Inc., which analyzes investment companies, argues that using market data to discover portfolio pumping is “naive.”

“There’s probably much more of this in the separate-account area,” he says. He also singles out specialists and traders as a source of abuse.

“Does it happen from time to time? I’m sure it does,” says Mr. Lipper. “Some of it may be on purpose. Some of it may be in reaction to [money] flows” in and out of funds.

John Collins, spokesman for the Investment Company Institute in Washington, says the mutual fund trade association is not aware of evidence that mutual fund managers act to artificially inflate the value of the securities funds they hold.

Mr. Collins adds that investigators must examine “all the possible sources of price movements before claiming that price pumping is the cause.”

But the possibility of portfolio pumping is being cited as a reason for greater disclosure of mutual fund holdings.

Mercer Bullard, founder and chief executive officer of mutual fund shareholder advocacy group Fund Democracy in Chevy Chase, Md., has petitioned the SEC to require funds to disclose holdings more often than the current twice-a-year standard.

Mr. Bullard says greater disclosure would ease concerns over evidence of portfolio shifts immediately before reporting periods.

The mutual fund industry opposes greater disclosure, arguing it would allow other traders to front-run them and hurt fund returns.