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Dear Shareholder:
Is the Mutual Fund Scandal for Real?? I’m afraid so. You may remember that I wrote about this as recently as the September 30th shareholder letter. At that time the revelations centered around a couple of brokers at Bank One, who were falsifying order times in order to trade after hours in the funds of Bank One, Janus, Strong and Nations Funds. I said I hoped the scandal would not go beyond the brokers to include any of the four funds’ management.
Strong Funds’ Chairman has resigned under similar circumstances.
What have these men (and others) done? To understand the answer to this question you have to know how stock funds are priced. Most funds price the stocks in their portfolios at 4:00 PM, EST, simultaneously with the close of the New York Stock Exchange. Important announcements are usually held until after 4:00 PM. If you place an order which is received by the fund before 4:00 PM you will buy shares at “today’s” price. Rules forbid orders placed after 4:00 PM to trade at “today’s” price. The illegal activity involved in each case was a scheme to get around these time restrictions by falsely stating the time of the order.
You need to know one additional thing. Funds routinely allow large brokerage firms an extra two or three hours to consolidate all their orders for that fund on any day. In return for this privilege the brokerage firm agrees contractually that it will only turn in orders to buy or sell that were received before 4:00 PM. If the brokerage firm doesn’t meet this obligation honestly, it can profit at the expense of long term investors in the fund.
For example, say, the price of a fund was $10 p/sh today, and then at 4:00 PM the price changed to $11 p/sh. A dishonest broker might back-time an order to buy a million shares before the 4:00 PM change, and immediately place an order to sell a million shares at the new price, making a dollar a share without risk. There are other variations on this strategy, all illegal.
If you think about it, it becomes obvious that an honest fund manager is going to detect this short-term activity very quickly. He is going to see very large amounts of money coming and going rapidly and he has an obligation to question this activity. Ultimately he has an obligation to stop this activity.
It appears that some of the fund managers of the country’s most reputable mutual funds have failed to ask the right questions and may have actually condoned this activity. Other individuals in high mutual fund management positions are accused of actually engaging in this activity for their own account, and at the expense of the very mutual fund(s) they manage.
Actual losses to shareholders are estimated in only tenths of a percent at most. The effect on a shareholders account is small at this level, but the activity is still cheating at the shareholder’s expense. Fund managers have a fiduciary responsibility to shareholders to protect their interest first. This amounts to a fiduciary failure by some of the largest and reputedly best firms in the business.
What about the Dupree Funds? First, bond funds’ prices do not change enough from day to day to make us a target of this activity. Nevertheless, we do have a couple of large brokerage firms that are permitted to submit orders as late as 4:00 PM., which is one hour after our 3:00 PM close. We have reviewed the history of this activity and find there have been no large orders that could be suspicious.
Finally, because we are a 100% no-load fund, no broker has any financial incentive to sell our funds.
Short Term Trading: There is such a thing as legal short term trading. An example would be an individual who places large orders to buy or sell based, perhaps, upon what he/she thinks the Federal Reserve is going to do next week.
It’s legal, but because short term trading can dilute long term investors’ asset value, we don’t permit this either. If large investors buy shares we question them thoroughly about how long they think they will be invested and whether they will be willing to give us advance warning when they want to redeem their shares.
Both my wife and I have good sized long term accounts in the Fund. Preserving that money takes some “looking after”. We’ve been doing that for years and we are not going to quit now. If you are coming to our funds for fast trading, you are going to be as disappointed as the man who slipped under the tent to see the circus and found he was in a revival meeting.
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