Lying to Investors Is Not.
While you would never know it from the press reports, and some pretty irresponsible statements from some regulators, market timing is not illegal. It is a perfectly legal trading strategy, which has been in existence for years, with the knowledge and consent of not only mutual fund companies, but virtually every securities regulator in the country.
The issue in the mutual fund scandal is not market timing, it is lying to investors – stating one thing in a prospectus, and doing another. That has always been illegal. Short term trading of mutual funds is not illegal. And what this recent scandal is about is not market timing, but lying, cheating and stealing money. Yes, market timing is legal, permissible, and engaged in by investors of every walk of life. Lying to investors and to regulators is illegal. Trading on inside information is illegal.
To date, most of the prosecutions over market-timing have been aimed at fund managers who violated their company’s policies and their fiduciary obligation to their investors by permitting big clients to engage in abusive trading. The only brokers who have run into trouble with regulators over market-timing is the group from Prudential, which allegedly used a deceptive scheme to help its customers place market-timing trades. We need to focus on the limited amount of prosecutions, since a very serious problem that is arising is that brokers and mutual fund employees are being investigated and losing their jobs for engaging in legal behavior that is being painted as illegal. These individuals, and their firms are being smeared in the press and being threatened with lawsuits, for legal and accepted business practices.
There is clearly a problem in the mutual fund industry, and we are now painting the entire industry with the same broad brush, we are destroying mutual funds, hedge funds, mutual fund executives, brokers, and hedge fund managers who have done nothing wrong, and we are contemplating new rules, new regulations, and ultimately additional costs to funds and investors, all in the name of catching fraud, and grabbing headlines.
The big bogey man today is market timing. There is nothing illegal about market timing. Market timing is a strategy where an investor attempts to “time” the market by buying, or selling, a mutual fund, or other investment, to take advantage of perceive market moves. Market timing services- companies that analyze particular markets and make suggestions as to what security or mutual fund to purchase, have been around for decades. However, today, the press has turned the term into a bad thing, by draping the term the words “mutual fund scandal”. Market timing is not illegal, it is not a fraud, and is a proper investment strategy.
We are not talking about late trading. While the media consistently confuses late trading and market timing, they are two very different practices. Late trading is buying or selling a fund after 4:00 based on the 4:00 price. That is the practice that Mr. Spitzer stated it is like betting on a horse race after the race has been run. A truism, at best, but late trading is not automatically illegal. There are good arguments that certain forms of late trading are legal, but this is an admitted gray area, and not as clear as the issue with mutual fund timing. We can leave that argument for another day, and stick to mutual fund timing.
Someone is going to read this and say OK Mark, if timing is not illegal, then what is the big to-do about? Interesting question, and since I posed it, I will answer it. Before I am misunderstood, I am not advocating market timing in mutual funds. If market timing is done to a significant degree in a fund where other investors are long term holds, the frequent trading can hurt the fund itself. But if a fund does not prohibit market timing, then it is permissible, and legal.
So, lets review. Profits are legal. Performing trades that are profitable is legal. Investing is legal, and short term investing is legal. Short term trading in mutual funds is also legal, and it is legal for a mutual fund to allow investors to engage in short term trading.
History of Market Timing and Mutual Fund Disclosures
A problem arose in the late 80s and early 90s with short term trading in mutual funds. As sector funds came into existence, investors began to use those sector funds as trading vehicles. The theory was simple – if the automotive industry was expected to be profitable in the coming months, rather than purchasing shares of the big three auto makers, an investor could purchase Fund X’s Automotive Manufacturer’s Fund; buying a basket of the sector’s stocks. As sector investors used the funds to make such trades, the costs of such trading increased the costs to the funds.
Because of the nature of mutual funds, were all investors monies are pooled into one fund, short term trading increases the costs to a fund, and ultimately to all shareholders in a fund. If short term trading is done to a significant degree in a particular fund, the impact can be significant, and affect portfolio balancing as well. All of this sector and short term trading was starting to have an impact on some of the funds, and therefore some of the funds decided to curb the practice by adding redemption fees. Those fees, ranging anywhere from .5% to 3%, were imposed on liquidations which occurred 30 days or less after purchase.
Such fees had an impact, in that they reduced the number of short term redemptions, and recouped some of the costs of the short term trading for the fund. The fund companies implemented the policy in some, or all of their funds, and disclosed same in the prospectus. What is important to note, is that the funds did not prohibit the practice. They used their business sense, and common sense, and charged the short term traders additional fees to recoup the additional costs. In other words, short term trade, or market time, all you want, just pay the fund an additional 3% when you do it.
Other funds, and fund families, flat out banned the practice, disclosing in their prospectus that they would not allow market-timing, under any circumstances.
Therefore you have three “categories” of funds – those that permit market timing, those that permit it but impose a fee, and those that prohibit it. Some “categories” of funds are better for different investors, but all are perfectly permissible.
No problem, a free market economy at work.
However, another methodology for dealing with the issue was to provide the fund manager with the ability to stop short term trading, without requiring him to do so. Fund prospectuses began to carry a disclosure similar to this:
So, lets review where we are. Liquidations of a mutual fund by an investor in a fund has a cost to the fund, and the other investors. This is true for every liquidation, in every fund. If someone takes money out of a fund at anytime, it hurts the fund, and ultimately the other shareholders. And, if you buy a fund today, and sell it 3 months from now at a profit, you took profits from me, since I have been in the fund since March 2000 and am still losing money. But your trade is not illegal, and the fund’s “missing” profits that you took out are simply part of the concept of mutual fund investing. Some investors in a mutual fund make more money than other investors in the same fund. Heck, depending on when one buys and sells, there are investors who lose money in the most profitable mutual funds.
But none of that is illegal.
Your three-month trade isn’t illegal, and you hurt the fund. But Mr. Gavin and Mr. Spitzer keep screaming that the profits of market timers are hurting the funds, and must be stopped. OF COURSE they are hurting the fund. Every profit taken out of the fund hurts the fund. So now we are talking about the holding period of a trade, and somehow arguing that the profit taken in a week hurts mutual fund shareholders more than a profit taken in 3 months. Sorry, a profit is a profit, and a loss is a loss.
But after stating the obvious, the question is why is that a problem? There are dozens of events that hurt mutual fund shareholders – in fact, it can be argued that every withdrawal of funds from a mutual fund hurts the other shareholders, as there is a cost to the fund associated with every single withdrawal of funds.
While trumpeting that the timers are taking profits from the funds, and the shareholders makes good press, the real question is is it illegal? A profit taken from the fund, whether the trade is a day old, or a week old, or a year old, hurts the fund. Even the SEC impliedly admits that market timing does not necessarily hurt shareholders. Take a look at an allegation from a recent SEC complaint against a mutual fund which was accused of permitting undisclosed market timing:
Short-term trading in mutual funds can be detrimental to long-term shareholders in those funds. Such trading can dilute the value of mutual fund shares to the extent that a trader may buy and sell shares rapidly and repeatedly take advantage of inefficiencies in the way mutual fund prices are determined. Dilution could occur if fund shares are over-priced or under-priced and redeeming shareholders receive proceeds based on the mis-valued shares. In addition, short-term trading can raise transaction costs for the fund, it can disrupt the fund’s stated portfolio management strategy, require a fund to maintain an elevated cash position, and result in lost opportunity costs and forced liquidations. Short-term trading can also result in unwanted taxable capital gains for fund shareholders and reduce the fund’s long-term performance. In short, while individual shareholders may profit from engaging in short-term trading of mutual fund shares, the costs associated with such trading are borne by all fund shareholders. Consequently, investment advisors often maintain policies and procedures to detect and prevent market timing and other short-term trading.
Forgive me for playing lawyer with you, but that is from an SEC complaint, and the words were chosen very carefully, as the SEC, like any other litigant, does not want to mislead the court in its complaint. So, we need to pay attention to the words that I have highlighted. The allegation, made by the SEC, is that short term trading CAN be detrimental, it CAN dilute the value, it COULD cause dilution, it CAN result in unwanted taxable gains. It could, it can, but even the SEC does not allege that it DOES cause dilution of value, that is DOES increase costs, or that it DOES result in taxable gains for the fund. It COULD do all of those things, but it does not necessarily do so.
In fact, the entire allegation is true for every liquidation of a mutual fund. Liquidations of mutual fund holdings by every fund holder – me, you, your next door neighbor, CAN cause dilution, those liquidations CAN result in trading costs for the firm, and they COULD result in dilution and unwanted capital gains. It doesn’t matter if we hold our investment for a day, a week or a year. When we sell, we can cause all of those problems. And depending on who sells, and when, the sales can have an enormous impact on the other shareholders.
Take for example the billions dollars of shares that were liquidated by Putnam investors after the Attorney General’s announcement. Those liquidations, obviously legal, DID increase the trading costs in the funds and DID result in unwanted capital gains. Now, were those liquidations illegal? Did Attorney General Gavin, whose announcements caused the massive liquidations of Putnam funds participate in a fraud or illegal conduct? Of course not. Some may want to blame him for his press releases, and his public statements which cause the liquidations, which had all of these effects on shareholder value, but they were certainly not illegal. I address that argument in another article – Where are the Regulators and Who is Watching Them?
And the last sentence is important – Consequently, investment advisors often maintain policies and procedures to detect and prevent market timing and other short-term trading. Another true statement, fund advisors OFTEN, not always, maintain policies and procedures to prevent short term trading.
So, none of this is illegal? Well, even I won’t go that far. Perfectly legal transactions can violate the law, depending on how they are accomplished, and the situation is not quite as simple as I just portrayed it.
The Current Problem with Market Timing
Short term traders cost mutual funds more than long term holders. I think that is a pretty clear concept. The investor who invests and sells 10 times in a year costs the fund more money in fees than the investor who buys and never sells. That is a pretty basic concept. It’s not the profits that they are taking out that is the problem, it is the in and out transaction costs that are the problem. The fact that they are trading the funds, rather than holding the funds also violates the concept of mutual funds, and it does remove profits, so taken all together, it is probably a good idea to stop short term trading in mutual funds, as the industry decided in the late 80s.
The problem comes in when mutual fund managers decided that not all market timing is bad, just some of it. The problem is when the fund tells the investing public that it is going to prohibit, or restrict, or penalize, short term trading, or market timing, and then it makes exemptions for certain investors. And then takes fees from those investors for making the exception, all the while not telling their other investors that they have made the exception.
The problem comes in the disclosures. Market timing is not illegal, but making a false statement in a prospectus is clearly a violation of law – at a minimum Section 10(b) of the Securities Exchange Act of 1934. And therein lies the problem with this entire mutual fund scandal – permitting market timing does NOT violate the prospectus of most mutual funds, and is NOT illegal. Our entire securities regulatory scheme is based on disclosure, and a very broad stroke concept is that you can do what you want, so long as you disclose it. Remember the blind pool offerings of the 80’s? Perfectly legal. They told you they were raising money and had no idea what they were going to do with it.
Back to market timing. Lets review. Short term trading of mutual funds is legal. However, since it can cause increased costs, and it can cause dilution, and since it can increase costs and decrease profits for fund shareholders, some funds have prohibited the practice, or have otherwise taken steps to deter such practices.
So, if you are a market timer, and you are short term trading a fund that does not prohibit the practice, you have done nothing wrong. If you are an executive at a mutual fund company, and your fund does not prohibit short term trading, and you allow it, you have done nothing wrong.
So, what the heck is all the screaming about? Take a look at the disclosures in the mutual funds that are in the news. For the most part, they do not prohibit market timing, and they do not claim that they do. Most of the funds simply say that they have the right to restrict redemptions (liquidations) and that they have the right in their discretion to reject or restrict trades. That says nothing about market timing, and in fact is a disclosure used to protect the fund and its investors.
Other funds say that they may enact policies to prohibit short term trading. They may do so; not they will do so. They aren’t making a promise, they are warning investors. In fact I submit that this disclosure is not to protect investors, but to warn them. The fund may prevent you in the future from engaging in short term trades.
The Market Timing Misrepresentation
Now, compare those disclosures to the disclosures made by Invesco. Invesco itself, and its CEO were recently charged in dual actions by the SEC and the NY Attorney General with fraud for allegedly violating the market timing policies reflected in the funds’ prospectus disclosures and having breached their fiduciary duties to the funds and their shareholders. See the SEC Press Release.
This is a very different situation however, and we are not talking about a fund that allowed market timing or short term trading. Here is the SEC’s allegation regarding Invesco’s disclosures about market timing and short term trading:
From at least 1997 through October 2003, the Invesco funds’ prospectuses uniformly disclosed that Invesco would limit shareholders to only “four exchanges out of each fund per twelve-month period.”
That disclosure is materially different than the others. In its prospectus, Invesco represented to that is would allow only 4 exchanges out of each fund in a twelve-month period. Not a problem, and since we all know that market timing is “bad” for a mutual fund, an important disclosure, and one that could be expected to attract investors who are concerned about the negative effect of short term trading on a fund.
However, if you tell your shareholders that you are going to limit liquidations to 4 a year, you better make sure that you limit those liquidations to 4 a year. Investors are relying on that representation, and I am confident that investors went into some of those funds because of the limitation on short term trades.
But did Invesco violate that representation?
Obviously, I do not know if they did or they didn’t, but looking at the SEC complaint, and assuming it is true (an admitted leap of faith) it alleges two things – one, that Invesco did not even track the liquidations of customers who had less than $100,000 in a fund. So, small investors could short term trade all they wanted, Invesco wasn’t even watching them. I am sure that the decision to do that was made on a cost analysis – short term trading by investors with less than $100,000 does not have much of an impact on a billion dollar fund, and the cost of monitoring such trading exceeds the benefit to the fund. However, they are violating the disclosure made in the prospectus, which is illegal, and puts the fund in a very precarious legal position.
While investors with less than $100,000 in a fund may not be a problem, the SEC also alleges in their complaint that:
Invesco made secret exceptions to its disclosed market timing policy for certain select large traders. These exceptions were not disclosed to other investors or the independent members of the boards of the funds, and were contrary to the statements in the prospectuses for the Invesco funds.
Between at least July 2001 and October 2003, Invesco permitted more than sixty separate broker dealers, hedge funds, and investment advisors to trade in excess of the prospectus restrictions on market timing. These select traders engaged in frequent trading designed to implement market timing strategies in at least 10 different Invesco funds. Invesco referred to those specific instances where it had a specific agreement with a market timer as “Special Situations.” In addition to the Special Situation agreements, Invesco also allowed other persons known to it to engage in frequent market timing activity which did not involve specific agreements.
I hate to be so blunt, but if that allegation is true, that is a fraud. You tell your investors that you will only allow 4 trades a year, and then you let Mr. Big Hedge Fund make dozens of trades a month, without telling anyone? That is a fraud, and a fraud that is made worse by the fact that you accepted additional fees to your management company (not the fund) from Mr. Big Hedge Fund for allowing him to violate your short term trading rules.
But this is the exception. Read the press reports about the other funds carefully. Some of them do not have any such rule, and they have apparently decided that short term trading is not a problem with their funds. So, why does the SEC think it is? Again, politicians doing what politicians do – ignoring their job by failing to catch the violators for 5, 6 even 7 years, then jumping on a political bandwagon, overreacting and creating new laws to make something illegal that shouldn’t be, or to make something illegal that is already illegal.
But the issue has turned into a feeding and publicity frenzy, once again. Suddenly every mutual fund family in the country is getting subpoenas, and executives across the board are being fired, for doing something that was in accord with company policy, that benefited the balance sheet of the mutual fund company and its shareholders and was perfectly legal!
As always, politicians seek headlines and the solution, according to these politicians, is the creation of new rules, new regulations and more bureaucracy. We don’t need more rules, more regulations or more regulators. We need enforcement of existing rules and prosecution of those who violate those rules. And we do not need political witchhunts where regulators force companies to fire individuals who did nothing wrong, simply for fodder for their own publicity mills.
We are a capitalist and free society. I do not pretend to be an economist or a market analyst and I will assume that the head of trading strategy at Really Big Mutual Fund Company knows more about the economics of operating a mutual fund than I do. If he decides that short term trading is appropriate in his fund, and does not want to prohibit the practice, who the heck is Elliot Spitzer to tell him otherwise? Either investors will agree, or they won’t agree – if they agree, they invest in the fund. If they don’t agree, they invest in another mutual fund.
That is apparently the situation at many mutual fund companies. They did NOT prohibit the practice, they didn’t say that they were going to prohibit the practice, and they did not lie to anyone. Market timers are apparently big business for mutual fund companies, and those companies allow the practice so long as it doesn’t materially hurt the fund or its shareholders. Lets keep in mind that the practice is legal, and it benefits another group of shareholders – the shareholders of the mutual fund companies themselves.
While the pundits are having a hard time quantifying the costs of market timing to mutual fund investors, if we assume that all of the disaster scenarios are correct, we know that a fund that allows market timing will have much higher transaction costs and fees, as well as lower profits. Funds that allow market timing will therefore find that investors will stay away from such funds, since they have higher fees and lower profits. This is capitalism at its best. Permit the practice, but it will get to a point where it affects your profits, and you will lose customers. Ultimately, the practice will stop, or will be restricted, because the fund manager will be losing investments because he is losing profits. And the world turns, and regulates itself. Free market economy, capitalism and investment self-interest all at work.
On the other hand, if the funds manager is such a great manager that he can have great profits, after higher fees and still permit market timing, the marketplace should reward him, and he should be allowed to continue earning those profits, attracting investors, and attracting market timers.
Our economy will take care of market timing and decide whether it is a “good” or “bad” thing. Slandering mutual fund companies and financial professionals is not the way to address this issue. More regulations are certainly not going to help.
Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.