In the early 1990’s, mutual fund companies occasionally allowed select institutional clients to trade fund shares rapidly, a practice known as market timing. But such trades were relatively small andusually limited to funds that held corporate bonds or mortgage-backed securities, hedge fund executives and others said.
I worked on Wall Street in the early- to mid-90’s, and this practice was taking place then, said Frank Partnoy, professor of law at the University of San Diego and the author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Times Books, 2003).
That changed after the stock market collapsed in 2000 and the easy money in initial stock offerings disappeared. Market timing in mutual funds the in-and-out trading of fund shares that is now the subject of intense regulatory scrutiny became a common investment strategy.
Hedge funds sought to identify discrepancies in fund share prices and to capitalize on them by rapid trades. To the extent that the market has opportunities that are structural, such as mispriced securities, that’s what hedge funds look for, said Gregg Berman, head of institutional business at RiskMetrics Group.
To understand why mutual fund companies would grant special trading privileges to hedge funds, privileges that cost their long- term shareholders untold millions in losses, you have to recall the climate in the securities market in 2000, hedge fund executives say. With stocks in free fall, mutual fund managers found it tough to generate good performance. As assets under management plummeted, so did management fees.
Fund managers, interested in keeping their fees up, were under pressure to attract fresh money or keep existing assets from disappearing. Allowing big investors to conduct market timing trades seemed to be one solution because in exchange for the privilege of conducting such trades, hedge funds would agree to invest more money in the mutual fund.
Even though mutual fund companies had policies against the frequent trading of fund shares, hedge fund managers of all stripes were soon striking deals to trade fund shares and attracting investors with promises of relatively easy gains. According to the lawyer for one broker under investigation for handling such trades, his client took up the practice when an investor walked unsolicited into the brokerage firm and requested it.
Mutual funds’ embrace of market timers is showing up in documents released by regulators investigating improper practices at funds. For example, the complaint against Putnam Investment Management, filed by Massachusetts regulators on Oct. 28, stated that the fund giant allowed one of its retirement plan clients, Boilermakers Local Lodge No. 5, to trade in and out of fund shares frequently because Putnam sought to expand its retirement plan business and keep the plans it already had happy. Such trading was forbidden for all customers, according to Putnam’s stated policy.
Putnam’s eagerness to accommodate the Boilermakers is reflected in an e-mail message dated Jan. 3, 2003, from a Putnam employee, Robert Gowdy, that said, Boilermakers No. 5 is a longstanding profitable client which was very instrumental in our winning $100 million in business from an associated organization, Boilermakers International.
Putnam said it regretted that market timing had occurred in its funds. But it said it had not committed fraud.
Market timing is a misnomer, of course. What these traders were doing was trying to capitalize on pricing anomalies or discrepancies in securities the fund held. This is also known as securities arbitrage.
The easiest way to profit in this manner is by trading in international mutual funds. These portfolios hold stocks that do not trade when U.S. markets are open but that may respond to the direction American markets take when the shares open for trading the next day. Furthermore, shares of foreign companies may not trade as frequently as big domestic stocks and therefore may be more likely to have stale prices than those of more liquid securities.
In the early 1990’s, market timers found their best opportunities in fixed-income funds, hedge fund experts said. Securities in junk bond funds, for example, do not trade as frequently as big-name stocks do; some do not even trade each day. Getting accurate prices on 300 illiquid securities is time-consuming and difficult for fund managers to do, so some bond prices in a portfolio were allowed to go stale. When interest rates moved significantly, this created great profit potential for investors who knew that the fund’s pricing of a certain bond had not been updated to reflect the rate move.
Still, the opportunities for profits in market timing were relatively small because mutual funds limited the amount of money they allowed investors to deploy in the strategy. In those days the funds were very reluctant to allow people to do this, one former hedge fund manager said. Most funds prohibited it; other funds might let you trade $5 million at a time but wouldn’t let you do $50 million because it would wreak havoc with the fund. You can’t go around and sell $500 million worth of junk bonds and buy them back the next day.
Partnoy said that he had researched market timing of mutual funds and traced the practice back to the 1920’s.
After the crash, there were stories about abuses of those practices, that some funds were giving information to arbitragers, the same kind of things they are doing today, he said. One rule in the Investment Company Act of 1940 was created to crack down on this practice.
But with hedge funds prowling for profit opportunities and mutual funds fearful of declining assets and management fees, it is not surprising that the practice became popular once again.
Profits to the fund companies seemed to take precedent, said Phil Edwards, who follows the mutual fund industry for Standard & Poor’s.
