Here's a quick way to gain some insight into how the securities industry came to its current lowly state: Type “mutual fund market timing” into your favorite search engine.
Given the spate of scandals plaguing the industry, you might expect to see a bunch of links to regulatory sites or maybe some headlines about the recent mutual fund trading scandals. In fact, what you'll get is an avalanche of how-to advice.
For all the gnashing of teeth and regulatory posturing, the fact is that market timing is as old as the mutual fund business itself — or at least as old as the family of funds concept. Since the 1920s, fund groups have sold investors on the ability to move free-of-charge among their funds. The logic of allowing a client to switch, for example, from a tech fund to a balanced equity or bond fund, is hard to argue with: The fund gets to keep the customers' assets under management, and the customer gets the flexibility to adapt his investing strategy to the current economic environment.
The fact that funds have eschewed charging for market-timing transactions does not mean, of course, that they are without cost. The transactions typically touch off transaction processing fees, and the purchases and redemptions also can have a ripple effect on the portfolios themselves. With this in mind, the SEC and other regulators have quietly accepted market timing in moderation.
Because it is in their best interest to do so, fund groups have tended to address frequent trading on their own. Some quietly allowed frequent account switches, reasoning that any negative effects of the shifts could be offset if investors availed themselves of their freedom of movement. Other funds placed limits on the frequency of switches, and some tried to reduce the attractiveness of market timing by assessing a 1 or 2 percent redemption fee on assets. (The SEC deemed 2 percent the highest amount that might “fairly” be charged to investors.) Finally, some other fund groups promoted market timing outright, for a variety of economic reasons.
Evolution and Devolution
As trading became a more global business and as technology improved, some investors sought to take advantage of price movements in international securities markets, which close earlier than U.S. exchanges. These investors paid attention to the portfolio makeup of an internationally oriented fund, and, if on a given day they noted a strong close in portfolio securities, they bought the fund on the assumption that the securities' movements would carry the fund higher. This brand of market timing is perfectly legal, so long as the transactions are conducted within the fund's parameters. After concluding a study of international mutual fund “gaming” in 1997, the SEC did nothing to stop or limit the practice.
But at some point, the laissez-faire oversight of market-timing gave rise to the unsavory behavior that morphed into our current scandals. Some fund officials began market timing their personal accounts, thereby raising questions about their fiduciary responsibility to fund investors. Others went a step further into so-called “late trading.” Late trading works like this: A fund's net-asset value (NAV) typically freezes at 4:00 p.m. If the value of some of the fund's components change overnight, or if there is some post-market announcement that might affect a security contained in the fund, the fund itself will not register the change until the market opens the next morning. Late traders use post-close movements in a fund's component securities to inform after-hours purchases of the fund, in many cases locking in sure-fire gains.
Let's take an example. Assume you know that a company with the ticker CSCO is to announce quarterly earnings after the close, and you also know that a particular fund has a high percentage of CSCO and other technology stocks. If CSCO's earnings are beyond consensus estimates, the price in the after-hours market will rise and the value of the fund's shares (all things being equal) will also rise on the next day's NAV.
But since a specific rule, Section 22(c)(1) of the Investment Company Act, has for decades required that fund orders placed after the setting of the day's NAV must be entered at the next day's NAV, this was not thought to be a possible activity.
However, after the SEC, under pressure from on-line firms to ease customer order bottlenecks, permitted funds to treat orders received by brokers before the NAV-setting as if they had been placed with the fund itself, an entire new business developed, as clearing entities set up platforms to affect these transactions. It comes as no surprise that, over time, technology trumped regulation, and orders were placed by institutional investors well after the close.
Three That Matter
Although all of the above have been widely discussed, three areas of the timing debacle have not received much coverage.
While most investors can view the specifics of a fund's holdings on a monthly or quarterly basis, some funds were supplying institutional buyers with day-by-day or week-by-week information. This allowed the institutions to narrow their buy orders from a shotgun blast to a laser beam, and thus exacerbated the timing issues.
The careful fabric of regulatory discipline for improper practices has been badly torn. The regulators, well aware of both traditional and international market timing, chose not to respond to it. Now, in an ex post facto world, brokers, as well as brokerage and fund executives, are being disciplined by their firms and face enforcement action for acting under the then-existing rules.
The regulators have estimated that timing transactions have cost investors “billions.” As bad as that sounds, it should be noted that the mutual fund industry manages seven trillion dollars of assets, and that there has been little or no discussion of the possibility that timing transactions and late trading may be neutral — or even positive — events for investors.
In short, what appears a simple case of betting on the winner of a race that has already been run has greater complexity than has been offered by regulators. And beyond this, the regulatory enforcement actions taken so far threaten to tear apart a traditionally balanced program of penalties for improper activities.
Scaring the pants off brokers, funds and fund investors because of a widely practiced yet marginal activity in a multi-trillion dollar industry is unlikely to be helpful to anyone.
Saul S. Cohen, who represents securities firms, is a partner in the law firm, Proskauer Rose in New York City.