Much Ado About Trading

When New York Attorney General Eliot Spitzer announced his investigations into improper mutual funds trading practices, the reaction in the press and on the Street was swift and overwhelmingly breathless. In a headline, Money magazine announced, The Great Fund Rip-Off. The Wall Street Journal warned that the questionable practices could cost investors 2 percent a year. Morningstar urged shareholders

When New York Attorney General Eliot Spitzer announced his investigations into improper mutual funds trading practices, the reaction in the press and on the Street was swift and overwhelmingly breathless.

In a headline, Money magazine announced, “The Great Fund Rip-Off.” The Wall Street Journal warned that the questionable practices could cost investors “2 percent a year.” Morningstar urged shareholders to pull out of the four fund companies named in Spitzer's complaint against Canary Capital Partners LLC — Bank of America, Bank One, Janus Capital and Strong Capital Management.

If you don't delve too far beneath these knee-jerk reactions, it would be easy to get the impression that mutual funds — regarded as a squeaky-clean investment during the bull market — now are at the beck-and-call of large institutional investors. Therefore, you might be inclined to accede to client requests to dump longtime holdings.

But before you make any moves, take a hard look at the charges and their true net effect upon retail investors. When you do so, you're likely to find this: For all the attention it has garnered, this scandal's net financial impact on the average investor is very small. And that means advisors' main concern should be guarding against an emotional overreaction to the news surrounding the Spitzer investigations.

In no way should this be interpreted as an apology for those who participated in the after-hours trading, an illegal practice. They should be punished, as will be a trader for Millennium Partners, who recently pleaded guilty to securities fraud for his after hours trading.

While Spitzer's probe will widen (he's requested more info from 20 companies), the fact is, we're hardly in a territory that warrants the hysteria we're seeing. Quite simply: Some institutional investors and fund families acted pretty sleazy. But the vast majority of fund shareholders haven't lost a penny. Even if your clients hold funds named in the complaint, chances are their losses were minuscule. Viewed next to the Enron fiasco or the savings and loan disaster of the 1980s, market timing is small potatoes, though you'd never know it from the attention it's receiving.

Why the Tempest's in a Teapot

Let's examine more closely the fallout of the practices Spitzer is scrutinizing. Say a fund has $99,000 invested in Southeast Asian stocks. The Asian markets close, and in a few hours good news from Wall Street begins pushing up U.S. stocks. Figuring that Asian stocks will rise the next day, a market-timer in New York buys $1,000 worth of the fund's shares. As expected, Asian markets climb. The fund also gains, but a bit less than the overall markets. The underperformance occurs because the portfolio holds the speculator's cash at the opening bell. In a rising market, cash serves as a drag. How much do the shareholders really lose? That depends on how quickly the portfolio manager puts the cash to work. If he invests the money immediately, the dilution could be tiny — a fraction of a percentage point — or nonexistent.

Jason Greene, a professor of finance at Georgia State University, studied patterns of fund flows and estimated the losses attributable to market timing in all categories of funds. He found no evidence of losses in domestic equity and bond funds. The biggest problem appeared in Asian funds, where shareholders appeared to suffer losses at an annual rate of 1 percent. That's a lot, compounded over a period of years, but when you consider the assets allocated to this type of fund, the actual dollar amount ripped off would be small. The average loss to investors in all international funds, including the Asian funds, overall was 0.5 percent. While troubling, the findings suggest that market timing only hurts a small group of investors. Of the $7 trillion invested in mutual funds, less than $5 billion is in Asian funds.

In the future, the losses could become great if the amount of speculative activity increases. In catching the practice at this stage, Spitzer might have headed off a calamity.

But so far the timing phenomenon is a small one. Janus claims that less than 0.25 percent of its $152 billion in assets were involved in the questionable trades, and there is no evidence to dispute this. In his complaint, Spitzer even cites emails indicating that the trading activity was limited. According to one, Strong permitted hedge fund Canary Capital Partners LLC to hold $18 million in a brokerage account and trade the money actively in five funds, including Strong Growth and Strong Dividend Income. The hedge fund was not permitted to trade more than 1 percent of a fund's assets in a day. In another email, Bank One said it would permit Canary to trade 0.5 percent of assets in each of five funds.

While market timing is a small factor, it is more significant than late trading. But unlike market timing, late trading is an illegal practice. This occurs when a speculator uses an under-the-table arrangement to buy fund shares after the markets close at 4 p.m. Like market timing, late trading can also dilute fund returns. Estimating the impact of late trading, Eric Zitzewitz, a professor at Stanford Business School, figures that long-term investors in domestic equity funds suffered annualized losses of 0.6 of a basis point (six-tenths of a basis point) because of the dilution that springs from late trading. Those in international funds lost five basis points. Zitzewitz notes that total losses from late trading are less than the costs of other problems long cited by academics, including index funds that charge steep fees.

Calming Clients

Whether or not they suffered significant losses, clients might insist on selling because they fear future problems at Janus and the other named companies. But according to Spitzer's complaint, Janus portfolio managers opposed market timing. (The sales people encouraged it.)

The portfolio managers now appear to be back in charge. Janus has employed a team of outside auditors who are supposed to ensure that no more questionable activities occur. Other companies in the spotlight will surely tighten safeguards.

The net negative results for clients who dump funds in reaction to the scandal might be incurring capital gains tax bills and losing access to some top-performing funds, including Janus Growth & Income, Strong Value and One Group Mid Cap Growth.

“If you sell the funds now, you may be running away from good managers who have done the right things, “says Phil Edwards, a managing director of Standard & Poor's, who suggests that fund shareholders stay put until more information about the case is known.

Clients who want to buy Asian funds should stick with ones that discourage trading by imposing redemption fees on shares held for a short period, such as 90 days. Seeking solutions for the timing problem, Zitzewitz found that redemption fees of 2 percent discourage the kind of short-term trading that market timers use. Top Asian funds with redemption fees include Excelsior Pacific/Asia, Fidelity Pacific Basin and Strong Asia Pacific.

To be sure, the redemption fees haven't stopped all the questionable activity. The potential rewards of timing volatile Asian funds have been so great that some speculators believed they could pay hefty penalties and still earn nice profits, Zitzewitz says.

But the days when speculators will trade Asian funds may be ending. With regulators considering more controls, hedge funds will be forced to try other strategies, and fund shareholders should have cause to celebrate the end of a small hazard.

Stamping out the Market Timers

These top-performing international funds impose redemption fees, penalties that scare away most short-term traders.
Fund Ticker 1-Year Return 3-Year Return 5-Year Return Redemption Fee Max. Front End Load Expense Ratio
Excelsior Pacific/Asia USPAX 8.00% -10.90% 10.10% 2.00% 0.00% 1.51%
Fidelity Pacific Basin FPBFX 13.00% -11.20% 9.90% 1.50% 0.00% 1.50%
First Eagle Overseas A SGOUX 27.40% 13.70% 16.10% 2.00% 5.00% 1.39%
Strong Asia Pacific SASPX 20.90% -5.00% 13.20% 1.00% 0.00% 2.00%
Templeton Foreign A TEMFX 10.80% -0.10% 7.90% 2.00% 5.75% 1.16%
Source: Morningstar. Returns through 8/31/03.
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