“Market Timing” the Modern Day Witch Hunt

With the mutual funds scandal still in full bloom and with fees and penalties on the guilty rolling in like prosecutors have hit the lottery, the term Market Timing constantly gets talked about like celebrity gossip. But like many investigations that go through Washington , what we hear and read has little to do with reality. How does the saying go, “Follow the Money and the Truth Shall Be Revealed.”

Some Scandal background.

Quite a few very high profile mutual fund firms like Putnam, The Strong Funds, and Mass Financial, along with a few notable brokerage firms like Prudential, have made the news over the last year, news most often titled along the lines of … “Market Timing Trading Scandal.” The big boy hedge funds like Canary Capital, are in on the act. These scandals implicate four fund companies — Janus Capital, Strong Financial, Bank of America and Bank One -- of after hours “Illegal” trading.

The headlines are right about the crimes being committed by these financial institutions. They are crimes, but they are not “Market Timing.”

The first of these crimes is really “After Close or After Market Trading.” This one is almost always labeled “Market Timing”, but its not . In these instances, the mutual fund company receives an order to buy or sell fund shares from either an inside fund manager (yes, their own firm) or outside management firm after Wall Street has closed for the day. For the normal investor or money manager, these trades would be processed at tomorrow's closing price. However for the select few, their trades were processed at that day's closing price. Who wouldn't want to trade on tomorrow's new today!

Here is an example: Let's say that Big Blue is issuing its earning report after the market close today. Unfortunately, the news is not so good. Tomorrow the stock price will most likely get hammered. However, “After Hours Trading” arrangements lets these “select” managers “Illegally” sell at essentially yesterday's (the markets already closed for the day) higher price with tonight's news. This is wrong. It steals from all other holders of Big Blue stock that must wait for tomorrow's market to sell. It's illegal. But this is not Market Timing. This is “After Market Trading” and there are already laws against this and these funds chose to break them. USA Today reported:

Regulators say Prudential knew about the activity ( after market trading* ) but failed to stop it. Prudential received an incredible influx of about 30,000 warnings and termination letters from fund companies during the past year but took no action, regulators allege. USAToday.com Posted 11/3/2003 11:09 PM      Updated 11/4/2003 1:05 PM *Added

These companies knew of the violation but wanted their inside manager to perform well and boost the bottom line, or wanted to keep the trading business from an outside manager. What ever the reason, it's nonetheless illegal, and it's still not Market Timing.

The second offense lumped into the Market Timing definition is actually a legal trade called “ Arbitrage of Stale Pricing.” In this trade, the manager places the buy or sell order during normal market hours and receives today price just like everyone else. So what's the problem? Let's look at an example to illustrate how the profits are being manipulated.

The greatest news in the world is revealed during US market hours, and as a result, the US markets have a banner day, say up 5 percent by the closing bell. The “astute” manager knows this great news should also cause the Japanese markets to soar. Because the Japanese, which are on the other side of the world, were not open when the news was released, did not have the opportunity to trade. The “astute” manager purchased a Japanese index fund traded in the US markets during regular market hours, but which has the “Stale Price” from yesterday's Japan market close and will most likely sell the shares the very next day, capturing the gain and minimizing the risk. This manager's accounts will benefit from growth they already knows is inevitable.

The suggested problem is the idea that this manager's action dilutes the gain the existing shareholder of the Japanese Index fund will receive. This sounds unfair and it is; but this is not illegal. The problem is not the manager's buy of a fund on Stale Pricing but that the Stale Price exists in the first place . Over the last five to ten years, mutual fund companies have been told repeatedly to fix stale pricing. Can it be fixed? Yes, investor friendly fund families like the Rydex Fund Group have had systems in place for years that locally corrects stale priced markets . However, these other mutual fund companies ignored the issue, allowing Stale Pricing to continue while their mutual fund insiders and selected few outside managers were making a killing at the shareholders expense, but now they've been caught – red handed.

And some have to pay:

USAToday.com Posted 11/3/2003 11: 09 PM      Updated 11/4/2003 1: 05 PM

Can all this be rectified?

Yes it can. But, like the fox guarding the hen house, the Mutual Fund industry has offered some solutions to curb, not the real problems - “Arbitrage of Stale Pricing ” and “ After Market Trading ”, but of an issue of their design called “Market Timing.” Please remember Market Timing is not the problem . The Mutual Fund Industry is misdirecting away from the issues that created the scandal towards a subject that will promote their own profits. Unfortunately, “Arbitrage of Stale Pricing ” and “ After Close Trading ” and “ Market Timing ” all sound like basically the same thing to the average person or moreover, the average congress person. Most persons outside the industry do not know the difference between these industry specific terms. The Mutual Fund Industry is taking advantage of this “tech talk” to void fixing the real problems while getting congress to enhance their profits and rid them of shareholder beneficial Market Timing. The industry earnestly wants to get rid of Market Timing and, as you will see, increase their profits at the shareholder expense. This is the heart of a deeper scandal.

What solution have they offered?

The favorite two are mandatory redemption fees and mandatory holding periods. Neither of these will address “ After Close Trading ” which is already against the law. Enforcing the law already on the books with perhaps a nickel jail time should do the trick. But they would never suggest putting away some of their own. While these solutions may deter the legal “ Arbitrage of Stale Price ” trading, they allow the Mutual Fund industry to avoid any costs and moral obligation to truly fix Stale Pricing . Rather than correctly addressing the Mutual Funds internal problems, these solutions are designed to penalize the individual investor (by limiting their right to protect and enhance their portfolios performance, through true“Market Timing”) while boosting the Mutual Funds own profitability.

The Mandatory redemption fees will fine the shareholder, on average, two percent penalty for selling their shares before the mandatory holding period, which can range from 30 days to one year. These are scandalous suggestions all on their own. Mandatory minimum holding periods with penalty fees will definitely deter the individual investor's ability to manage and protect their portfolio. By imposing these fees and holding periods the industry is forcing individual share holder to delay the selling of poor performing funds or forcing them to dwell in poor performing markets. Further more, in the case of an emergency withdrawal, unrelated to market timing, the shareholder will still pay right into the coffers of the Mutual Fund.

The deeper scandal again is that these recent transactions are not Market Timing at all, but the Mutual Fund industry wants the press, public and especially Washington to associate these wrong doings with Market Timing. The Mutual Fund industry has wanted to do away with Market Timers for years. On their bottom line, it raises transactions costs yet delivers no recognizable benefit. Yes, it benefits the investor by achieving lower risk and higher returns but not for the Mutual Fund Company. With true Market Timing the investor wins. The mutual fund company wins too, they just don't have control over it. Moreover, Market Timing can, and often does actually enhance the Mutual Funds Assets in allowing the individual account higher returns, which increases the funds overall money under management. It also drastically increases market liquidity. As it should, because who's money is it anyway.

The Mutual Fund industry wants their shareholders to stay put. Understandably, they want to keep cost at a minimum. Although, Mutual Fund Companies offer a myriad of funds, what they want is for the investor to buy two or three different versions of fund “5 Star” and remain idle for the rest of their lives. Picture yourself driving down the Mutual Fund ten lane highway. The Fund industry wants their shareholders to get into a lane and stay there regardless of the traffic flow or direction (Bear Markets). This creates low cost and high profits — for them not for you. You wouldn't drive this way. You shouldn't invest this way. Granted some drivers do want to pick a lane and stay there. Others may want to get to their destination sooner or safer than one lane traveling allows. When things look bad up ahead, you switch lanes. As in driving your car or steering your portfolio, the choice should be yours. The fact is, times change, not changing with them is a fastest way to extinction.

O.K. If these transactions are not Market Timing transactions then what is?

Market Timing: What is the true definition?

Let's look at the newspaper:

USA Today stated:

“Market timing is rapid, in-and-out trading to take advantage of differences between the fund's share price, which is set once a day, and current market conditions. It's not illegal, but most fund companies have policies against it.”

USAToday.com Posted 11/3/2003 11: 09 PM      Updated 11/4/2003 1: 05 PM

Wrong again. USA Today almost defined Stale Pricing but missed that definition as well.

Market Timing is buying the market, fund, stocks or bonds when you anticipate that the price is going to move up and selling it when you expect the price is going to depreciate. It is used primarily as a defense to protect an investor's portfolio from declining markets. Another name for this investment style is Absolute Return or Dynamic Asset Allocation.

The financial industry, promoted by the Mutual Fund Companies and brokerage firms, leads many investors to believe their mutual fund manager will protect them from the dreaded Bear Market. This could not be further from the truth. Stock funds buy stocks. Even in the worst market they are prohibited from selling them and protecting the funds by moving to cash. The 2000-2003 Bear market proved this. The Mutual Fund Industry Failed to protect their client's assets and investors lost trillions .

America was built by a free market economy. We would never let anybody tell us how long we must own our home before we could sells. We would never let anybody put restrictions on when and how often we traded our cars. Why should we tolerate such restriction of choice for our investment portfolios?

The bottom line is, the recent bear market removed trillions from investor's portfolios. At the same time it also reduced the management fees that the Mutual Fund Industry collected on those trillions. Now caught, their illegal trading must be stopped. They are looking for new avenues of profit. At the expense of the shareholder, these redemption fees and mandatory long term holding periods will help the Mutual Fund Industry win by making back some of the hundreds of millions that they have lost in management revenue. From these fees, generous donations will be made to political campaigns and the politician will win. But the individual investor will lose as their portfolio will have higher risk and reduced returns. But, you know what they say, “Two out of three isn't bad.”