Morningstar Pans PBHG for Market Timing
December 1, 2003
Morningstar has recommended that investors dump shares of 11 PBHG funds after its founders were charged with securities fraud for allowing two of the firm's clients to trade billions of dollars in and out of its funds.
In the latest instance of gross misconduct by fund executives, the Philadelphia-based fund shop and founders Gary Pilgrim and Harold Baxter are accused of allowing hedge fund Appalachian Trails to market time three of its funds from 1998 to at least 2001, according to charges filed by the Securities and Exchange Commission and New York Attorney General Eliot Spitzer.
The firm also allegedly struck a deal with New York brokerage Wall Street Discount Corp. (WSDC) that enabled its clients to make short-term trades in PBHG funds. PBHG also provided the portfolio holdings of some of its funds to aid their timing efforts, the complaint said. Pilgrim and Baxter resigned from the company a week before the charges were handed down.
"Gary Pilgrim and Harold Baxter failed to uphold their end of the bargain with the mutual fund investors who entrusted them with their hard-earned savings," said Stephen Cutler, director, SEC division of enforcement. "The allegations in our complaint describe a course of conduct that was unethical, illegal and just plain wrong."
The case adds a new wrinkle to the fund scandal in that it is the first case where a fund manager has been accused of not only trading in and out of his own funds, but also allowing a hedge fund he owned to do the timing. Pilgrim held a substantial stake in Appalachian while also serving as chief portfolio manager of the PBHG Growth Fund, PBHG Technology and Communications Fund and PBHG Core Growth Fund, the funds named in Spitzer's complaint. Essentially, it alleges he put his own interests ahead of the individuals who had entrusted him with their money
Pilgrim, acting with Baxter's approval, permitted Appalachian to rapidly trade in and out of the PBHG Growth Fund along with a number of other funds. Despite scripting a policy in its prospectus that limited the number of exchanges, Appalachian was permitted to make almost 100 exchanges in and out of the fund in 2000 and 2001. In exchange for the free pass, Pilgrim received a substantial share of the millions of dollars in profits that Appalachian made from trading in that particular fund.
Meanwhile, the average Joe who put his money into that fund on a buy-and-hold basis would have lost 60% of his investment during that time frame, the complaint said.
"They were willing to bend the rules for Appalachian and WSDC while maintaining that they were serious about shutting down or curbing timer activity on at least a couple of occasions," said Paul Herbert, a mutual fund analyst at Morningstar of Chicago.
The smoking gun in this case was an e-mail Pilgrim sent to a fellow PBHG portfolio manager expressing his moral dilemma over market timing. "I think timers are a loser for our shareholders and probably not even in our business interests," he wrote. "So, I would give them the boot. Period." Unfortunately, his resolve came too late, regulators said.
Baxter also manipulated his close friendship with WSDC President Alan Lederfeind. The complaint accuses Baxter of arranging to give Lederfeind's clients a special exemption from the exchange limits imposed on all other fund shareholders and disclosed portfolio holdings of certain funds in order to facilitate timing activities. The suit also alleges that there were many other market timers involved in PBHG funds, activity that generated at least $573 million in assets.
"His interests were clearly divided between those of the manager of the fund, the steward of the shareholders' money in PBHG Growth Fund and his own investment in the hedge fund Appalachian Trails," Herbert said
Breaking down the numbers, regulators found that as of April 21, 2001, investments by clients who engaged in market timing eclipsed $385 million in the PBHG Growth Fund, or 11% of the assets in the fund. More than $91 million of market timing assets were found in PBHG Technology & Communications Fund, comprising 7.5% of its assets.
With respect to the PBHG Emerging Growth Fund, there was $53 million invested by timers, representing 8% of the fund's total assets. By July 12, 2001, timer assets in the PBHG Growth Fund had swelled to more than $466 million or nearly 14% of fund assets.
"If the fund's portfolio manager had to keep cash on hand to meet this client's potential redemptions, it may have been substantial enough to keep the fund from fully participating in gains when stocks were rising," Herbert said.
Given the fact that top individuals were complicit in the trading abuses, the hefty amount of money invested by market timers and their apparent influence over the firm's policies, Morningstar regards these issues as "very serious."