Mutual-Fund Managers Get Scrutiny

New SEC rules will require closer tabs on the personal trading managers do on the side

As Americans pour ever more money into mutual funds, the federal government wants to ensure that fund managers are subject to effective codes of ethics - and are abiding by them.

By late spring or early summer, the Securities and Exchange Commission (SEC) plans to tighten rules governing trading by mutual-fund managers in securities held in their own personal accounts.

The planned regulatory action is unusual because the SEC finds no major problems with the current rules governing personal trading or with their enforcement. And, although the industry supports the move, it has drawn fire from some mutual-fund workers, who worry about negative and perhaps unintended consequences (see related stories on this page).

But the move is not a question of doing the unnecessary, SEC officials say. Although acknowledging solid adherence to ethics in the mutual-fund industry, SEC officials say the changes are needed to preserve a high level of public trust in mutual funds.

Personal-trading rules discourage portfolio managers (individuals who control investments for thousands of customers) from using their insider status for selfish advantage, often to the detriment of customers.

One notorious abuse is called "front running," where a fund manager buys or sells stock for his or her own account immediately before buying or selling a large amount of that same stock for the mutual fund. The fund manager thereby may influence the stock price in his or her favor.

The key SEC rule changes are:

*Every fund will have to publicly disclose its code of ethics on personal trading by noting in its prospectus that such a code exists and by filing a copy with the SEC, thus making the document public. This is a return to a policy the SEC abandoned some years ago. Under the 1940 Investment Company Act, fund groups are already required to have detailed ethics codes, including on personal trading. The 1940 law prohibits fraudulent, deceptive, or manipulative acts by managers in personal stock trades.

*Each fund's board of directors must review each year the fund's code of ethics and compliance with it.

*Each fund must have a person responsible for reviewing the fund manager's reports on personal trading. Most funds already have such a person.

Mutual-fund company executives say solid ethics already pervade their industry, which they contend is more closely monitored than any other segment of the pooled-investment community.

Barry Barbash, head of the SEC's investment management division in Washington, agrees that the fund industry in fact has been essentially free of major scandal for a long time. He adds that the Investment Company Institute (ICI) in Washington, representing the fund industry, has been very active over the past two years in "developing and promoting better procedures in personal trading." The ICI supports the new SEC changes.

There are two basic reasons why the SEC is acting now to tighten the rules on personal trading. First, mutual funds have become dominant financial institutions in US life. More than 38 million investors have $2.3 trillion in more than 5,000 funds.

In the first four months of this year alone, $99 billion of new money was socked into equity funds. SEC Chairman Arthur Levitt notes that this amounts to 4.4 percent of US personal income, a figure slightly higher than the nation's total annual personal savings rate. "Every single savings dollar that households produced" in this period went into stock mutual funds, he figures.

The other reason behind the rule changes is the pressure of negative publicity. This was triggered first in January 1994, when Invesco Funds of Denver fired prominent fund manager John Kaweske, alleging he had failed to report a number of his personal securities trades. (In February 1995, the SEC initiated court action against this manager.)

Later in 1994, Fidelity Investments Inc. of Boston, the largest US investment company, reviewed and updated its own procedures on personal trading.

Congress got into the act when Rep. Edward Markey (D) of Massachusetts wrote SEC chairman Levitt in January 1994 - soon after Mr. Kaweske was fired - to inquire about the personal-trading issue.

The SEC then did an exhaustive examination of the personal investment activities of mutual-fund personnel, especially fund managers, releasing a report in September 1994. It found no pattern of abuse and few cases of high volumes of personal trading.

At about the same time, the ICI did its own major investigation and report, released in May, 1994. Executives from top US fund groups spearheaded the investigation. The ICI also found no pattern of abuse, and it found that the companies' codes largely exceeded the requirements of law.

The 1994 ICI study recommended more than 15 substantive changes in codes of ethics, and a later survey by the ICI, in April 1995, showed that most funds had adopted the new rules quickly.

Fund Industry Braces for Big Chill on Personal Trades

Personal stock trading may be reigned in more than the modest scope of new Securities and Exchange Commission (SEC) regulations would indicate, says James Riepe, managing director of mutual funds for T. Rowe Price Inc. in Baltimore.

To illustrate the point, Mr. Riepe tells of one of his fund managers came to him and said that in the new era of "heightened awareness," it's "no problem to buy a stock, but a really big one to sell it" for a profit.

Riepe asked the manager what he meant. The answer: "Say I check with our manager [of another T. Rowe Price fund] holding ... the stock I want to sell. He says he does not plan to sell it. So I sell my shares. Then he changes his mind five days later and sells his fund's shares. Bingo - the SEC would be after me."

This analysis, if correct, could have a chilling effect on personal trading, Riepe says. "Even if we have a good paper trail for such a legitimate case," Riepe says, "the SEC would probably look at it and just say, 'Sure!' " So, after the conversation, Riepe called other top industry executives. He says they agreed the fund manager's analysis was probably right.

In essence, the mutual-fund industry worries that the pressures of public trust and heightened awareness regarding personal trading (through press coverage and political input from Congress), may cause a few additional trading rules to have a much stronger effect than would appear on the surface.

But has the fund industry gained anything?

Yes, Riepe says. The changes yield gains in public trust for the industry. Such trust is crucial for the industry to keep thriving.


After Invesco fund manager John Kaweske was fired in 1994 for undisclosed stock trades, potential abuses in personal trading by fund managers became big news.

It's a topic that "makes good copy," laments Paul Stevens, general counsel for the Investment Company Institute (ICI), a mutual-fund industry trade group in Washington. What the press doesn't often touch on, he asserts, is the "complex, detailed rules, and their long history, that actually produce ethical trading."

The press focused especially on one fund manager, Jeffrey Vinik, who resigned May 23 as manager of Fidelity's $56 billion Magellan fund after four years on the job.

In the months prior to his departure, Vinik also had been in the news for moving Magellan heavily into bonds just before a bond downturn.

Several press reports said Mr. Vinik made 500 personal trades in 1995 alone. In fact, Fidelity - the nation's largest mutual-fund group - had a "cowboy" image on the personal-trading issue before it tightened its in-house rules in 1994. But the US Securities and Exchange Commission, which regularly reviews such trades, found no reason to move against Vinik or Fidelity.

In fact, in a highly unusual move, the SEC repudiated as inaccurate an April 19, 1996, Washington Post report claiming Vinik and other Fidelity managers were under federal investigation for personal trades.

"Jeff Vinik was pilloried for bettering 65 percent of the funds he competes against - I don't blame him for leaving," says James Riepe, managing director of mutual funds at T. Rowe Price Inc., a Fidelity rival.

Vinik now is founding his own investment company in Boston.

Fidelity has strict rules on personal trading, says Teri Kilduff, spokeswoman for the Boston firm. One Fidelity fund manager, Brian Posner, reportedly will not do personal trades, but invests his own money in the fund he manages, Equity Income II. Fidelity would not grant the Monitor an interview with Mr. Posner.

The fund industry overwhelmingly wants to be able to continue to grant its fund managers the right to do personal trading. To deny this, top executives say, would drain the industry of its best investment experts, says T. Rowe Price's Riepe.

More galling to fund insiders than press treatment of Vinik, however, is what SEC chairman Arthur Levitt has said in public about personal trades.

Mr. Levitt said May 22 at a major ICI conference in Washington: "If I were a [fund] director, I would have reservations about portfolio managers trading for their own account."

Fund insiders say that was a glass of cold water right in the face of industry members who have worked for two years with SEC staff on tighter trading rules. They say such comments play into the hands of a press already disinclined to look carefully at current protections.

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