Latest fund probe: Selective disclosure

The next big shoe to drop on the mutual fund industry may be masquerading as a slipper in the back of the closet.

So far, most of the hullabaloo related to the mutual fund scandal has revolved around the issue of illegal or unethical trading. But as regulators continue to snoop for violations, it’s fast becoming clear that some fund companies have also been allowing certain clients, or potential clients, to peek into their funds’ holdings well ahead of individual investors.

Selective disclosure of portfolio holdings, which gives traders the opportunity to buy or sell securities ahead of the fund, is likely to emerge as the next hot-button issue to face the $7 trillion fund industry, say industry analysts, securities lawyers, advisers and consultants.

“I think it’ll have a life of its own,” says Max Rottersman, a consultant with FundExpenses .com in New York. “People have let it slide.”

Unlike market timing or late-day trading, selective portfolio disclosure is likely to strike a chord with individual investors, he says.

“It’s insider information,” Mr. Rottersman says. “The public understands inside information.”

Julie Allecta, a San Francisco-based mutual fund lawyer at Paul Hastings Janofsky & Walker LLP of Washington, agrees.

“It’s a much more clear-cut case of fraud,” she says.

Another San Francisco-based fund lawyer, Mark Perlow of Kirkpatrick & Lockhart LLP in Pittsburgh, says the issue of selective portfolio disclosure is ready to jump to the forefront of the widening fund scandal at any time.

“Your crystal ball is as good as mine,” he says. “But the SEC has – as part of its examinations of the mutual fund companies – asked questions about selective disclosure of portfolio holdings, so we can be confident that the truth will [come] out.”

Indeed, selective portfolio disclosure was mentioned in passing in New York State Attorney General Eliot L. Spitzer’s complaint against Canary Capital Partners LLC of Secaucus, N.J., with regard to Strong Capital Management Inc. of Menomonee Falls, Wis.

Also, at a meeting of the Securities and Exchange Commission last Wednesday, the commissioners discussed the selective-disclosure issue in the context of market timing.

Predictably, some fund companies are scrambling to head regulators off at the pass.

Denver’s Janus Capital Group Inc., for example, plans to begin disclosing its funds’ holdings monthly, with a 30-day lag. The change in policy is slated to take effect Dec. 31.

The SEC currently requires fund companies to report full holdings every six months, with a two-month lag. The commission is currently considering a proposal that would require funds to disclose their holdings quarterly, with a 60-day lag.

Gary Pollock, president of Bay Isle Financial LLC, which manages $1.1 billion and is owned by Janus, says monthly disclosure could stamp out many shenanigans.

“There’s nothing like some visibility to be self-regulating, in a sense,” says the Oakland, Calif.-based adviser. “Advisers vote with their feet.”

Mr. Pollock says advisers would be far more likely to make quick, effective decisions if they saw, for instance, intense trading activity one month that did not seem to fit with a long-term investing strategy.

Value of Advice

Maybe so, but as fund companies and regulators play a high-stakes game of political one-upmanship, financial advisers say they are troubled by the seemingly sudden shift on portfolio holdings disclosure.

These advisers recognize that the value of their own practices rests on the advice they dispense to clients. If portfolio holdings are disclosed too frequently, they worry clients will simply follow the lead of fund managers – rather than rely on them for investment advice.

“I see both sides of the coin,” says Deborah Voso, president of Voso Financial Advisers LLC in Frederick, Md., which has $50 million under management.

She adds that she likes the SEC’s proposed quarterly requirement but that she wouldn’t want to see the SEC force funds into even more-frequent disclosures.

Carlo A. Panaccione, principal of the Navigation Group, which manages $150 million in Redwood Shores, Calif., also likes the idea of quarterly disclosures. But he would rather see the SEC focus its energy on making existing rules more clear rather than creating new ones.

“Don’t create crooks out of people not given clear guidance,” he says.

Indeed, the rules governing portfolio disclosure are hazy.

In recent years, for instance, it’s become acceptable for some newspapers and magazines to be given fund holdings information that is updated beyond what has been reported in findings. The information is used in articles featuring the fund.

Robert Powell, a Salem, Mass.-based mutual fund consultant, believes that brokerage houses with fund wrap programs have successfully obtained holdings information by threatening not to buy the funds otherwise.

Advisers and analysts say they don’t see the harm in this behavior if the information is used strictly to assure properly diversified portfolios.

But investors may be less sympathetic when they see the scope of the problem, says Mr. Rottersman.

Declining to provide specifics, he says he knows of a bank that was selectively disclosing holdings to favored institutions until a company lawyer stopped the practice.

“If one bank was doing it, any number of them was doing it,” Mr. Rottersman says.