In funds, it can be a matter of timing

Arbitrageurs take advantage of price inefficiencies

By KATHLEEN GALLAGHER

kgallagher@journalsentinel.com, Journal Sentinel

Sunday, November 30, 2003

To understand the wrongs that New York Attorney General Eliot Spitzer is trying to right in the mutual fund industry, you have to understand two things many people don’t: market timing and late trading.

Late trading is clearly illegal — and easier to define. It involves sneaking in buy or sell orders after the deadline and getting the closing price even though the investor has the advantage of information released after the market closed.

In his Sept. 3 complaint against Canary Capital Partners LLC, Spitzer said Bank of America and Security Trust Co. allowed Canary to engage in late trading in their funds.

Market timing isn’t as clear-cut. Spitzer accused Bank One, Janus and Menomonee Falls-based Strong Capital Management Inc. of allowing Canary to engage in market timing. That’s also what press leaks have suggested Richard S. Strong personally did in his firm’s funds.

Market timing is often described as rapid trading in and out of mutual funds. But the key is that market timers, no matter how often they trade, take advantage of price inefficiencies in the stocks the funds hold.

“Anyone who has ever bought or sold stock knows that at any point in time, there is not one ‘fair price,’ ” said Mark Ready, an associate professor of finance at the University of Wisconsin- Madison who worked for a year on regulatory issues at the SEC and who specializes in market structure. “The NAV calculation completely ignores this issue.”

The NAV, or net asset value, of a mutual fund is calculated once a day, using the closing prices of all its holdings. Some of those closing prices may not be completely accurate, though. For example, a stock’s last trade may occur an hour before the market closes. In that case, the price from that trade will be the stock’s closing price, even if the market has risen and the bid for the stock is higher.

The mutual funds that are most profitable for market timers — and therefore the ones where shareholders get hurt the most by timers — are international funds, according to a research paper about arbitrage-proofing mutual funds by Eric Zitzewitz, an assistant professor of economics at the Stanford Graduate School of Business. The paper was cited by Spitzer in his complaint against Canary.

Zitzewitz estimates international fund investors’ holdings in 2001 were diluted by $4.3 billion because of market timers.

Although market timing is supposedly frowned upon in the mutual fund industry, some say it’s widespread.

“A lot of people trade in mutual funds,” said Robert J. Bukowski, a senior consultant at Alpha Investment Consulting Group in Milwaukee. His firm has identified at least 20 hedge funds that do nothing but market timing.

“There’s a price difference they think it’s worth taking advantage of — that’s what arbitrageurs do — and they do it daily in mutual funds and stocks,” he said. “When is it legal and when is it illegal — that’s what we’re all trying to figure out.”

In the simplest form, a market timer would buy shares of a fund where a good portion of the securities in it were not accurately priced.

Another method, Ready says, is that “mutual fund muggers” could short-sell thinly traded stocks in which the fund has positions, pushing down the stock prices. The traders then turn around and buy shares in the mutual fund. Theoretically, they would would be buying fund shares at the depressed price they helped create — a price that would move up as soon as they got out of the short position.

Timers have the best chance of making big profits if they know the holdings of the funds they’re using. That’s why it was important for Spitzer to show the fund companies were providing lists of portfolio holdings to the market timers. Spitzer’s complaint alleges that on four occasions Strong gave lists of its holdings to Canary during a period when other shareholders got them just once.

Market timing may skim profits from longer-term shareholders and create extra transaction and administrative costs they must bear — but someone still has to prove how many dollars of damage that really created. For many, the bigger issue is the way the fund companies helped the “muggers” by providing lists of holdings and overlooking frequent trading.

“It’s the arrangements around the market timing that are upsetting,” said Paul Herbert, an analyst at Morningstar. “I don’t think mutual funds are the vehicle for this type of activity — and I don’t think you set up rules for one set of investors and not for another.”

BILLIONS IN LOSSES

Eric Zitzewitz, an assistant professor of economics at Stanford University, estimates that investors lose as much as $4 billion a year because of market timers exploiting that the true prices of all the stocks in a mutual fund sometimes aren’t reflected in the fund’s net asset value. Here’s a breakdown from Zitzewitz of which fund investors have been hurt the most.

Assets

lost

Fund category

Regionally focused international equity funds 1.60%

General international equity funds 0.81

Specialty equity funds 0.33

Latin American and global equity funds 0.23

Small- and mid-cap U.S. equity funds 0.12

* Estimated average annual losses to NAV arbitrageurs from 1998 through Oct. 2001. Source: Eric Zitzewitz, Stanford University