IMHO: Trading Places

November 7, 2003 ( - Over the past two months, trading improprieties have been alleged at one mutual fund company after another, and there is little sign that we have yet seen the last - or the worst - of these.

The vast majority to date have involved the actions of brokers employed by, or associated with, a mutual fund complex – or in some cases, managers and executives at the fund complexes themselves.

Yet confronted with the worst scandal in the industry’s history, last week the mutual fund industry’s chief lobbying group put forth a  proposal that was strikingly unoriginal and misguided – truly a “cure” that will be anything but, and one that is significantly worse than the disease they claim to be saving us from.

Bad Acts

Two types of trading violations have been alleged: late trading , or buying mutual-fund shares after the market close at that day’s closing price; and market timing , which involves taking advantage of market-moving events after the close of the market, when the funds’ daily prices are set based on the net-asset value of the portfolios.   Market timing is not technically against the law, but most mutual fund companies prohibit it as costly to other fund investors – and many claim to discourage such activities in their prospectuses.   “Late” trading is illegal – but most daily valuation retirement programs currently rely (and for the past 20 years have relied) on agreements whereby the recordkeeper captures participant trading instructions prior to the 4 p.m. cutoff, but does not communicate those movements to the fund companies until later in the evening.   That type of activity would not constitute late trading under current law – but there are proposals floating around that could change all that.  

For example, the Investment Company Institute (ICI) purports to solve the problem by recommending a solution that places the burden – and the cost – on millions of innocent mutual fund shareholders.   They would do this by first insisting that all trades be received by the fund company prior to the 4 p.m. ET cut-off…not in the hands of an intermediary, such as a recordkeeper…in the hands of the fund company itself; secondly, to deal with the problem of market timing by imposing a 2% redemption charge on trades in ANY mutual fund that occurred within 5 business days of their purchase.

“Blanket” Solution?

The first so-called solution would be laughable, were it not so blatantly unfair to the millions of mutual fund investors within the nation’s retirement plans.   Most of the trading problems alleged to date seem to involve people AT the fund companies, not participants at employer sponsored plans, and not members of the general public.   Requiring that all trades be delivered to the fund complex presumes that there are no problems at the point of delivery (and there clearly are).   More critically, imposing that requirement will have an immediate – and dramatic – impact on services to retirement programs, such as 401(k)s.   It’s been 20 years since the industry has had to cut participant trading off at – or worse, the day before – in order to get the orders to the fund companies by4 p.m.  

Yet, the ICI proposal would return us all to those days when the flexibility of multiple fund family offerings consigned plan sponsors to a choice of programs derided by some as “yester-daily.”   I might initiate a rebalancing request today – that won’t actually sell units until tomorrow – that won’t purchase units in the new funds until the day after that – and I won’t know the end result of that reallocation until the day after that.   Distributions, loans, etc., all could be subject to the same delays.   Think how much fun it will be to reeducate participants about this new, “improved” process.

However, the second proposal is, in many ways, more onerous.   The market-timing the proposal purports to redress has been totally confined to international funds thus far - funds that, based on how some firms value those portfolios, have been subject to a delay in pricing impact that has allowed attentive investors to take advantage of short-term fluctuations in price.   A number of mutual funds already employ a well-recognized way to counter this - "fair value pricing" - where fund companies adjust share prices to reflect the impact of news that occurred after some stocks in the portfolio (like those in foreign markets) quit trading, based on what they believe will happen when the company's stock starts trading again.   It's not as precise (and surely the industry could work out some more precise standards in short fashion), but it's widely used - and it helps keep market-timers at bay.  

However, rather than propose this - or a better version - as a standard, the ICI instead proposes that redemption fees be imposed on trading in ALL mutual funds, which not only misses an opportunity to address the real problem, it imposes an administrative burden on all investors in all funds - even those that are truly not vulnerable to timing.   Consider the participant who has been making regular payroll contributions to his or her 401(k), then decides to take a loan, chooses to reallocate his existing balances, or perhaps must request a hardship withdrawal from funds that include a purchase coincidentally made during the prior 5 days.   That purchase would be subject to the redemption penalty - and even that ignores the costly accounting nightmare that would be imposed on the recordkeeping systems to track and impose the penalty (and guess who will pay for THAT?).   And then those fees would have to be physically remitted to the fund that they could be reallocated to ALL holders of that fund, under the ICI proposal.

I'm not altogether sure how this would be applied to retirement plans, which generally trade through omnibus accounts.   Would the recordkeeper have to track the trades at a participant level, and then be required to remit the fees as a separate transaction?   Would a redemption fee be imposed on EVERY omnibus trade made by the retirement plan, regardless of the investment period of the individual participant investor?   Would omnibus accounting be exempted altogether?   It isn't yet clear.  

What is clear is that there are better ways to block market-timing trades at the participant level (recordkeepers routinely track the date of last contribution, for example) - and the ICI proposal fails to consider them.

My 11-year-old son watches a cartoon called Invader Zim - a somewhat inept creature from another planet who frequently expresses his frustration at the people on THIS planet with a simple phrase - "You speak craziness!!"   IMHO, it's an apt response to this proposal.