Sep. 14–MARKET-TIMING ALARM SOUNDS: Insiders and academics have long known that the values assigned to fund shares at daily market closings were faulty. Ordinary investors are learning that othershave gained from their ignorance. Nearly 75 years ago, an ambitious crime-fighter named Eliot–one “l,” not two–made headlines.
Eliot Ness busted folks who supplied something people wanted: a daily glass of beer, even stale beer, at their evening meal.
In the lingo of economics, this urge is called the liquidity preference. It lies at the heart of the current anti-crime campaign by Eliot Spitzer, attorney general of New York.
Most mutual funds are marketed as long-term, sober investments. But investors want the daily net asset value, or NAV, of their funds published in their morning newspaper.
The public’s right to purchase and redeem fund shares daily through the fund company is one of three essential appeals of fund investing. The other two are diversification of investments and professional investment management on behalf of fund shareholders.
Spitzer charged that several mutual fund management companies, for their own profit at the expense of their fund shareholders, colluded with an investment firm to corrupt one of the three pillars of the system. The goal was to exploit a flaw in the process of setting daily values of mutual fund shares.
Like drinkers during Prohibition, few investors tracking their funds understand the costly mischief attached to getting them their daily dose.
Spitzer termed the violations “market timing,” which usually refers to the dubious attempt to guess the direction of market prices. In fact, the scheme was virtually a sure bet.
“Market timing is a bit of a misnomer here,” said Roger Edelen, director of research at ReFlow Management, a California firm that assists mutual funds in managing their liquidity needs by buying and redeeming fund shares. “You’re timing the fund’s pricing system.”
Ness’ career went into a steep decline after Americans repealed Prohibition and allowed booze to flow freely between sellers and buyers.
Distancing yourself from the NAV opportunists could require you to repeal your mutual fund investment program in favor of investments that more freely reflect market prices.
Spitzer alleged that a private investment fund, Canary Capital Partners of New Jersey, conspired with four mutual fund sponsors–Bank of America’s Nations Funds, Bank One’s One Group, Janus Capital Group and Strong Capital Management–to violate laws prohibiting after-hours trading of mutual fund shares or fraudulent preference of one fund shareholder over another.
“The full extent of this complicated fraud is not known,” Spitzer said in announcing a plea agreement with Canary.
What has been known for decades, at least to Wall Street insiders and academics, is the flaw in determining the net asset value of mutual fund shares. The flaw opens the door to the scheme.
“The fundamental problem is that the fund manager must come up with an [NAV], and it’s just not good enough to take the last sale price” of the underlying securities, said Edelen, who has written extensively on the issue.
Here’s the problem: In order to provide you a periodic NAV, mutual fund companies add up the latest prices of the securities in the portfolio as of a moment in time. In most cases, funds calculate the NAV once a day, as of 4 p.m. New York time.
But many securities in the portfolio may not have traded for hours before the 4 p.m. cutoff. This problem is especially acute with mutual funds that invest in Asia, where markets are closed during daytime hours in America.
Funds that hold thinly traded domestic stocks, such as small-cap stocks, confront the same problem. At 4 p.m. each day, the prices of many stocks are stale–the last price they traded at does not reflect late-breaking news.
As a result, daily NAVs of many mutual fund shares set at 4 p.m. fail to capture current market conditions. Not until at least tomorrow’s 4 p.m. NAV is news from late today embedded in the NAV.
Market professionals long ago realized that riskless profits could be made buying or selling mutual fund shares late in the day when late news breaks.
A systematic process of buying or selling mutual fund shares after news breaks late in the day can produce an investment windfall, even if you make only a handful of such trades each year.
An investor who seldom trades fund shares and therefore never pays high redemption fees imposed by many funds on so-called market timers can profit from the stale-price flaw.
“This is a perfectly legal trade, if you get in before the 4 p.m. deadline,” said Edelen. “U.S. small-cap and mid-cap stocks do not trade enough to have fresh prices at 4 p.m.”
Solutions to the stale-price problem, such as increasing redemption fees or subjectively guessing at what the NAV should be at 4 p.m., could penalize investors not engaged in the scheme. These solutions fail to address the underlying problem.
GLOBAL INVESTING: James Atkinson of the California-based Guinness Atkinson Funds said investors have become accustomed to the 24-hour, seven-days-a-week reality of global investing. His firm cuts off sales of its Asia Focus and China & Hong Kong funds at 9:30 a.m. New York time to limit trades based on stale prices.
That helps, said Atkinson. But changing the sales deadline has not been widely accepted in the mutual fund industry, which seems devoted to uniform procedures for all funds, he said.
High redemption fees for in-and-out traders are another answer, he said.
“These guys are professionals. They want to game the system,” Atkinson said. “We know we can’t keep you out, but you’re going to have to pay the freight.”
Atkinson acknowledged that another answer may lie in reviewing the essentials of mutual fund investing.
Diversification remains a universal goal, but professional management and liquidity are viewed differently today.
“We’ve changed what we’re delivering,” Atkinson said. “We’re delivering access to an asset class. Do we need mutual funds to do that? Not necessarily.”
Indeed, long-term investors who want to participate in stocks, bonds and cash investments are penalized by short-term investors who are darting in and out of traditional funds at an increasing rate. High turnover prompted by hair-trigger investors is a major drag on mutual fund performance.
Two alternatives are available.
Wealthy investors place money with professional managers in separately managed accounts. The money is managed in many cases by the same individuals who manage mutual funds, but without the expensive baggage of mutual fund shares. In the case of hedge funds and other vehicles, the investor typically must agree not to cash in the investment for a lengthy period.
A more attractive alternative could be exchange-traded funds, which trade like stocks on major exchanges.
ETFs are similar to index mutual funds, covering a wide range of investment themes. But they are bought and sold continuously between investors. The fund company does not enter into the process to set an NAV.
“One advantage of ETFs is that they are continuously priced all day, whether or not the underlying securities trade,” said Lee Kranefuss, chief executive of the iShares unit of Barclays Global Investors.
Moreover, rapid-fire investors are penalized individually in dealing in ETFs through trading commissions, said Kranefuss, who oversees 80 iShares ETFs. Buy-and-hold investors in the same funds do not pay such penalties.
If you must go through the swinging doors of the market liquidity gin mill, you’ll have to deal with the high prices, as well as the bandits. But you shouldn’t be allowed to drag the rest of us with you.
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