OPINION: THE ETHICAL CODES THAT MONEY MANAGEMENT FIRMS ADOPT ARE DESIGNED FOR THE CONVENIENCE OF PORTFOLIO MANAGERS RATHER THAN THE PROTECTION OF CLIENTS: WHOSE MONEY ARE THEY MANAGING YOURS OR THEIRS?

The murky world of personal investing by employees of money managers has seldom been opened up for public scrutiny. Most investors are not aware that the portfolio manager handling their assets may very well be making investments for himself at the same time he is investing on their behalf. The Securities and Exchange Commission has long recognized that such dual activity can be harmful to clients, but has failed to take appropriate action to prevent abuses.

When a portfolio manager or other investment professional at a mutual fund or investment advisory firm buys or sells stocks for personal profit at the same time that he or she is investing for clients, the clients can be harmed. The investment fund manager faces a classic conflict of interest. On the one hand, he wants to buy the stock at the best price for his client. On the other, he wants it for himself at the best price possible.

The amount of money handled by money managers has gotten to be so great that it is not at all unlikely that buying large amounts of stock for clients could cause the price of the stock to rise. The law says the employee of the money management firm should first buy the stock for his client. His duty to his client should come before personal interests. To risk damaging a client by delaying an order would violate the money manager’s fiduciary duty.

Well, I’m here to tell you this happens all too often. Fund managers do personally profit at the expense of client accounts by buying stocks first for themselves and only later for their clients. This is called front running, and it is illegal.

Front running occurs when a money manager seeks to profit personally as the firm’s massive stock buying power eventually pushes up the price of a stock he previously bought. There are many, many other ways in which personal investing can hurt clients. For example, a money manager may simply choose to buy the best stocks for himself and not for his client portfolios.

Why are abuses occurring in this area? Why is the law not effec
tive? There are a number of reasons.

Federal securities laws generally permit fund managers and other employees of investment advisory firms to invest for their personal accounts in the very same securities they are buying or selling for their clients.

A do-it-yourself code of ethics

It is true that mutual fund money managers are required by the SEC to adopt an internal code of ethics to protect investors from being harmed by the personal investing activities of their fund managers. But the SEC has consistently left it up to money managers themselves to set their own standards on personal investing.

The Investment Company Institute, the national association representing the mutual fund industry, has effectively lobbied against the establishment of rigorous standards in this area, arguing instead that mutual fund organizations be permitted great latitude in designing their ethical codes. The ICI has recommended to the SEC that any further toughening of standards to obviate conflicts of interest, prevent and detect abusive practices, and preserve investor confidence be only voluntary on the part of its members.

As a result, the internal codes of ethics money managers are required by law to adopt do not adequately protect investors. They are not comprehensive enough, they are antiquated, complex, cumbersome, confusing and generally too weak. These ethical codes represent the collective thinking of a small group of senior portfolio managers within a company regarding how much restriction of their personal investing they are willing to tolerate. The ethical codes money management firms adopt are designed for the convenience of the portfolio managers rather than the protection of clients.

Furthermore, money managers are not required to disclose their code of ethics – the rules they live by – to their clients. I have asked the firms that manage my money for a copy of their codes of ethics and not one has agreed to disclose it to me. It’s there to protect me but I can’t see it. If something exists for my ben
efit, I’d like to see it.

Furthermore, unlike in the case of “soft dollars,” where the SEC has historically required disclosure to investors and is currently considering greater disclosure requirements, here the SEC has never required disclosure of the risks involved. This is an area that involves the most serious conflicts of interest and ethical concerns imaginable, yet investors have been kept completely in the dark.

Everybody’s in the dark

To make matters worse, money managers aren’t required to disclose, even to the SEC, the personal investments of their portfolio managers – even those who repeatedly violate personal trading laws – except perhaps in extreme cases. Investors cannot learn how actively the person they have hired to manage their money is managing his own money – possibly to their detriment – or how often he has broken the law in his personal investing.

The only outsiders to lay their eyes on records of personal investing violations are SEC examiners who review them as part of their regular scheduled inspections of money managers. And it’s extremely easy for a firm to conceal such abuses.

The time has come to bring personal investing by money managers out of the closet and into the public domain. The industry should not be allowed to continue to conceal from investors how actively engaged the people they hired to manage their money are in managing their own.

If we can’t see what our money manager is doing for his personal profit, how can we evaluate whether he is prudently handling the conflict of interest between his personal interests and our own?

By far, I prefer these records to be in the public domain where I can analyze them and come to my own conclusions, rather than rely on secret internal documents the SEC is supposedly reviewing for my benefit or industry self-regulation.

A new fiduciary principle may be emerging in the area of personal investing by money managers. In today’s brave new world of investment management, professional money managers who offer thei
r services to the investing public must be prepared to answer the question: Are you in the business of managing client money or your own?

At a minimum, money managers must be prepared to disclose and defend their personal investing activities.

Mr. Siedle was a lawyer with the Securities and Exchange Commission and Putnam Investments.