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MUTUAL FUND OFFENSES

Market Timing ...

Market timing—or frequent trading in and out of mutual funds—is illegal only if prohibited by the prospectus of the fund, or if favoritism has been shown toward employees or favorite customers. It is a difficult issue for mutual funds because frequent trading has always been a part of the industry, and because share liquidity and the shareholder’s right of redemption have been basic tenets of funds at least since passage of the Investment Company Act of 1940. The regulatory environment has always been strongly in favor of the rights of shareholders to redeem and freely exchange shares.

But, in addition to the disruption of the orderly management process of a fund, frequent trading requires fund managers to hold more cash to meet redemptions and results in increased transactions costs for other investors. Further, market timing is especially harmful for international funds investing in Asia, where markets may close 12 or more hours before the 4:00 p.m. EST close for mutual funds in the U.S. It has been estimated that such funds could lose as much as 2% of net asset value (NAV) in a single day by knowledgeable investors buying the fund at the U.S. close after substantial trading in the post-close Asian market has pushed prices up there relative to the “stale” Asian close prices used for U.S. NAV purposes.

Examples also exist where out-of-date or false pricing has been deliberately used in U.S. mutual funds to allow knowledgeable investors to profit from incorrectly reported daily NAV prices.

In addition to these examples where stale or incorrect prices allow profit to be made, investors will sometimes use mutual funds or indexes (“index funds”) to arbitrage mispriced index or futures prices elsewhere. Further, wealthy clients and hedge funds will sometimes trade in and out of funds because it is cheaper than purchasing the same securities in the cash market.

Regrettably, some management firms have been implicated in directly defrauding their own mutual funds by promoting such practices.

See Market Timing, Late Trading and Other Mutual Fund Abuse in the United States