What can you do about the mutual fund scandal?

The recent Wall Street scandals now have a disturbing parallel in the mutual fund business. New York’s Attorney General, Elliot Spitzer has caught several mutual funds and a hedge fund with their hands in fund shareholders’ pockets. Putnam Investments has been accused of fraud against shareholders. The news is bad – even mutual funds don’t seem to be safe investments. Can you do anything to protect yourself?

In this article, we’ll tell you how fund companies and their employees have helped others to take advantage of innocent investors. In the case of Putnam, employees themselves helped themselves to profits innocent investors had earned. We’ll also provide details on Sensible Financial™‘s three recommendations for protecting your investments:

• Invest in Exchange Traded Funds (ETFs) where possible. They are naturally protected against unfair market timing.
• If you can’t buy ETFs, or strongly prefer traditional mutual funds, seek out funds with stiff redemption fees - they deter unfair market timers.
• Finally, for asset classes where you prefer traditional funds without redemption fees, be sure to select a mutual fund company with strong reputation for placing shareholders first.

You may have heard that “market timing” is the cause of this mutual fund scandal. What is market timing, and who cares anyway?

Market timing is a legitimate investment strategy. The traditional market timer attempts to buy into the market before it goes up, and sell out before it goes down (sounds familiar, doesn’t it? – buy low, sell high). Many academic studies have found that market timers are rarely, if ever, successful. Market timing is a wonderful strategy, but no one has ever figured out how to do it systematically.

However, no one would deny the effectiveness of “market timers” who are able to trade with the benefit of hindsight. The “market timing” at the root of the mutual fund scandal takes advantage of different operating hours in securities exchanges around the world. For example, New York and Tokyo are fourteen hours apart. When the New York markets close at 4 PM, it is 6 AM in Tokyo – soon the Tokyo markets will be opening, and Tokyo prices will reflect the results of the day just past in New York.

Mutual fund prices are based on the most recent closing price for each relevant exchange. For a US based Japanese equity mutual fund (let’s call it the “Sushi Fund”), trades occur at the 4 PM New York prices of the Japanese securities held by the fund. But there has been no update on those prices since 4 PM Tokyo time the day before – 2 AM this morning New York time. A whole day of news has emerged since then, and the newly dawning day’s prices in Tokyo will reflect that news. If the day has been a favorable one in New York, then opening prices on the Tokyo exchange are likely to be higher than yesterday’s closing prices –reflected in the quoted price of our Sushi Fund.

Basically, the unfair “market timer” of the scandal invests heavily in the Sushi Fund when the news of the day in New York has been favorable for Japanese stocks, and sells when that news is fully reflected in the price of the Sushi Fund. This unfair “market timer” knows he or she is buying low – today’s New York Sushi Fund price is yesterday’s Tokyo price, and the “market timer” is buying based on today’s information.

Those old prices are also called ‘stale prices,’ for obvious reasons. In fact, it would be more accurate to call this a stale pricing scandal rather than a market timing scandal. There would be no opportunity for the “market timer” to make money by buying late in the day if the price paid reflected the most recent information.

Now, what’s wrong with trading based on stale prices? Who gets hurt, after all? Unfortunately, long-term Sushi Fund shareholders take smaller profits to pay for the profits of those who can buy at stale prices.

Think of it this way. Suppose the Sushi Fund holds just one Japanese security – Samurai Inc.

Figure 1 illustrates how stale prices work. At the end of one particular day in Tokyo, Samurai is trading at $10 per share. The Sushi Fund holds 10 shares, for a total value of $100. Therefore, each of the 50 shares of the Sushi Fund is worth $2. Now, suppose a favorable day in New York. The late buyer predicts that Samurai will go up, and decides to buy $100 worth of the Sushi Fund. But the Sushi Fund is still trading as if there is no favorable news about Samurai. At the price of $2, our late buyer can afford 50 shares. The Sushi Fund’s holdings are now 10 shares of Samurai and $100 cash. When the Tokyo market opens, the Sushi Fund invests the $100 in Samurai, which is now trading at $20 per share. So, the Sushi Fund can afford 5 more shares. After that purchase, the Sushi Fund holds 15 shares of Samurai at $20 per share, for a value of $300. There are 100 shares of Sushi fund, so the price of Sushi Fund is $3 per share.

The original Sushi Fund investors have a gain of $1 per share, and so has the late buyer. Doesn’t seem fair, does it? The late buyer makes the same gain as the long term investor, in just one day.

What would be fairer? Well, suppose that the Sushi Fund adjusted its price to reflect predicted changes in the price of Samurai. Then the offering price of the Sushi Fund at 4 PM New York time would reflect the (likely) higher price of Samurai. The 10 shares of Samurai would be worth $20 each or $200, so the 50 existing shares of Sushi Fund would be priced at $4 each. The late buyer would invest $100 at that same $4 per share, and now could buy only 25 shares. The Sushi Fund again would buy 5 shares of Samurai with the late buyer’s $100 investment, and would own 15 shares at $20 or $300 worth. The 75 shares of Sushi Fund would be worth $4 each. The existing Sushi Fund investors would have doubled their money (from $2 to $4 per share), and the late buyer would have gained nothing. “Buy and hold” investors earn good returns, and the opportunistic late buyer gets no gain.

But why is late buying at stale prices a scandal? The world isn’t always fair, and late buying is legal, right? Well…not exactly. There are basically two things wrong:

1. Most mutual funds have policies in place that are specifically designed to discourage late buyers (“market timers”). The fund advisors in the scandal – BankOne, Bank of America, Janus, Strong, etc. enforced those policies unevenly, allowing a select few to take advantage of the stale prices. They took payments from “market timers” to allow them to profit at the expense of other (longer term) shareholders. This preference for one group of shareholders over another runs directly counter to one of the core principles of the 1940 Act of Congress authorizing mutual funds – equal treatment of all shareholders.
2. In the case of Putnam Investments, the “market timing” shareholder was the portfolio manager, an employee of the advisor! Putnam failed in its fiduciary responsibility to the shareholders. This is why we’ve seen such a strong reaction from pension funds – Massachusetts, Texas, Rhode Island and others have moved their assets from Putnam to other managers.

So, what can you do to protect yourself from the late-buying “market timers” while the legal process seeks to identify and punish the guilty, and Congress and the SEC move to restructure regulation to make sure that “nothing like this ever happens again?” Sensible Financial has three recommendations:

1. Invest in Exchange Traded Funds (ETFs) where possible. They are naturally protected against late buying market timers. ETFs trade throughout the day, reflecting the market’s incorporation of information in real time. So, in our example, the Sushi Fund would have increased in price throughout the day as the US market did. There would be no stale prices for late buying market timers to take advantage of. Furthermore, the structure of ETFs is different from traditional mutual funds: increases in the size of the fund result from the exchange of the underlying securities for fund shares – in our example, a direct trade of Samurai stock in exchange for Sushi Fund shares. Each side has a strong incentive to get a fair price, which will happen only if Samurai shares are priced high enough, and Sushi Fund shares are too.
2. If you can’t buy ETFs, or strongly prefer traditional mutual funds, seek out funds with stiff redemption fees - they deter “market timers.” Many funds, especially index and international funds, have introduced these fees, levied only on shares held for a relatively short period of time. Since you (as a savvy client of Sensible Financial) are a long-term investor, not a short-term speculator or market timer, these fees are of no concern to you.
3. Finally, for asset classes where you prefer traditional funds without redemption fees, be sure to select a mutual fund company with strong reputation for placing shareholders first – Vanguard, Bridgeway, T Rowe Price and American funds all placed high on this criterion in a recent poll of fee only advisors. These companies are most likely to enforce their rules against short term trading, to the advantage of long-term shareholders.

As always, if you’d like assistance with your mutual fund investments or have concerns not addressed in the article, please contact us at Sensible Financial for a discussion focused on your specific issues.

¹Bob Veres, Inside Information.