The Open Secret of the Mutual Fund Industry

By Markets Fool.com

"Being on a mutual fund board is the most comfortable position in corporate America." Former SEC Chairman Arthur Levitt

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Have you ever wondered how mutual fund managers select their portfolios?

It seems like it would be obvious, that portfolio selection is all about projections and earnings calls and number crunching. But as a new study shows, that isn't all there is to it.

The importance of fund directors
After a pricing scandal in the industry in 2003, mutual funds began favoring independent directors for their boards. In fact, the number of mutual fund boards comprised of at least 75% independents went from 46% in 1996 to 88% in 2009.

That completely makes sense: You would think independent board members would rein in unnecessary or harmful policies owing to their external (and presumably disinterested) status.

However, a recent study has discovered a disturbing trend in the mutual fund industry: Board members seem to influence stock-holding -- and in a very interesting way.

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Portfolio allocations
Looking at 856 directors and the mutual funds they advised, the study uncovered that these mutual funds hold 25% larger stakes in the stock of their director's company compared to similar funds. That may sound like a fluke, except that the higher allocation persistently occurs after the director comes on board.

What's worse, if the director changes jobs to another corporation, the overweighting in company stock tends to follow. In other words, the fund starts to invest more heavily in the director's new company.

It's actually a pretty good strategy for the mutual fund: The study found that in the quarter after buying the director's stock, the stock earns an abnormal return (that is, a return above a value-weighted portfolio's) of over 2%. In the quarter after a sale of the stock, it earns an abnormal return of negative 3.76%.

Provided the analysis is correct (it looks reasonable from my point of view), that's just a bit too convenient to be random.

Not only is the relationship good for the fund, it's good for the director: Higher trading returns like these are directly related to the probability that the director keeps his or her position at the mutual fund.

What does it mean for me?
If you're a mutual fund investor, you might be getting a little performance boost without realizing it due to these personal connections.

But this is an important issue to be aware of. These kinds of connections are not fair (and this kind of trading is presumably not legal), but they exist throughout the financial industry. In a field where information means everything, and where careers obviously mean something too, there is plenty of opportunity for rule-bending maneuvers that make people look better.

These are things you should know about as an investor because they illustrate how much sway individuals can hold in what we like to think of as a clear-cut market environment. While we might want it to be so, perfect information and fair trading are simply not what you should expect.

Of course, if you're already feeling very well-aware of these issues, you might be astute enough to notice a strange sort of silver lining: Pay attention to what mutual funds are doing in their directors' stocks, and you might very well have the makings of a cute little investment strategy.

The article The Open Secret of the Mutual Fund Industry originally appeared on Fool.com.

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