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SEC Examines Funds for Portfolio Pumping


WASHINGTON D.C. - An SEC examination has targeted between 30 to 40 mutual funds that are suspected of artificially inflating their quarter-end performance by engaging in a trading scheme known as portfolio pumping, said Lori Richards, director of the SEC's office of compliance, inspections and examinations.

"We've identified the funds that have increased in value regularly," she said. "Now we are going in and looking at the trading activity in the securities that are held by those funds."

Richards made her comments late last week at a conference on directors' issues sponsored by the Mutual Fund Directors Education Council of Chicago.

The examination covers the funds' quarter-end performances over six quarters, she said. Many of the funds under investigation have increased in value three to four percent on the last day of the quarter several quarters in a row, Richards said. She declined to name the funds being examined.

The examination covered a variety of funds, she said.

"We looked at an asset value variation and identified 30 to 40 that followed a pattern," she said. However, one common factor among all of the funds being examined was that they trade small-cap and thinly-traded securities, she said. The examination is being conducted by a task force from the SEC's office of compliance and investment management, Richards said.

Data from Morningstar of Chicago recording upticks in fund returns on the last day of each quarter beginning with the fourth quarter in 1998 through the second quarter of 2000, indicates funds that rose three percent on one or two quarter-end days are fairly common. But few funds rose to that degree on the single day more than three quarters in that period, according to the figures.

The FirstarMicroCap institutional fund is one such fund. From the last quarter of 1998 to the first quarter of 2000, the fund had an average jump of 3.80 percent in returns on the last day of each quarter. Steve Dale, a spokesperson for the firm in Milwaukee, Wis. did not immediately return a call seeking comment.

The International Equity Fund of Ark Mutual Funds of Baltimore had a similar pattern but even more pronounced spikes in returns. The fund has had an average 36.60 percent increase on the last days of the first, third and fourth quarters of 1999 and the first two quarters of 2000, according to Morningstar.

However, none of Ark's funds are included in the SEC examination, said Micheal Mattingly, a spokesperson for the firm. Morningstar's data is also not accurate because it does not factor in the fund's merger with another international equity fund, she said.

"This is really just a situation of apples and oranges," she said.

Van Wagoner Funds of San Francisco has three funds that repeatedly had performance spikes on the last day of the fourth and second quarters, according to Morningstar. The Van Wagoner Emerging Growth Fund posted a 4.58 percent rise on the last day of the fourth quarter of 1998 and a 5.77 percent increase on the last day of the second quarter in 1999 and 2000, according to the data. The Van Wagoner Technology fund, similarly, had a 3.70 percent increase on the last day of the fourth quarter in 1998 and a 4.65 and 6.18 percent increase, respectively, on the last day of the second quarters of 1999 and 2000. The firm's Micro-Cap Growth fund posted similar spikes on the last days of the fourth and second quarters in 1998 through 2000, according to the data. However, none of Van Wagoner's funds are included in the SEC examination, said Peter Kris, a company spokesperson.

The returns of other funds, including the BlackRock Micro-Cap Equity (institutional) fund and the Dreyfus Founders Discovery fund, spiked above three percent on the last days of four quarters. Calls to both firms were not immediately returned.

In its examination, the SEC is now trying to identify which securities held by the funds in question fueled the increase in quarter-end performance as well as trading activity in those securities on the last few days of the quarter, Richards said.

"There could be lots of other traders in these securities that could cause the price to increase," she said.

Funds have an incentive to post higher returns on the last few days of each quarter because performance is often measured using the returns from the last day of each quarter and portfolio managers' bonuses are often based on quarterly performance, said Mercer Bullard, president and founder of Fund Democracy LLC of Chevy Chase, Md., and former assistant chief counsel at the SEC's division of investment management.

In July RT Capital Management, a unit of Royal Bank of Canada, paid nearly $2 million in fines after the Ontario Securities Commission filed charges against the firm for portfolio pumping, according to the Canadian regulator.

That case prompted the SEC to launch its own examination in October, Richards said.

"The case that was brought by the Ontario Securities Commission I thought was evidence of a fact pattern that I wondered could be duplicated here," she said. "That started us wondering and we started looking at it in a dramatic way."

In the case against RT Capital, the Ontario Securities Commission found that RT capital traded 26 different Canadian securities held by the firms' funds on the last day of the quarter in an effort to boost the value of those securities and, consequently, the funds.

The SEC, however, might have a more difficult time filing charges against a fund alleging portfolio pumping, said Bullard. In order for the SEC to bring such a case, it has to prove that portfolio pumping harmed shareholders, he said. The SEC would have to prove that, by purchasing a security that went up in value, subsequently increasing the value of the fund, the fund's shareholders were harmed, he said.

That is sufficiently difficult that it makes an SEC case against a fund unlikely, he said.

"The SEC has never been willing to sue someone just on principles and they are very conservative," he said.