By Palash R. Ghosh
As the performance correlation among global markets has increased in recent months, fund managers have noticed a growing incidence of short-term market-timers in the ranks of their shareholders -- high-stakes players who switch their money out of a domestic fund and into an international fund in order to exploit the anticipated gain there. Later, they may switch back to an onshore fund to capture an expected gain here.
This behavior is problematic for fund companies, as it hikes their administrative expenses and forces portfolio managers to keep an abnormally high cash position to maintain high liquidity. As a result, more and more fund companies are rethinking their shareholder trading policies.
In recent meetings with fund groups, Standard & Poor's Fund Services analysts have encountered at least three fund groups (Salomon Smith Barney, Dresdner RCM, and Artisan) that are exploring ways to deal with the situation, including adding a 30-day redemption fee to their international funds and working with their distribution units to identify short-term traders and deny them access to the funds.
"Fund companies have recognized over the last year or so an increased incidence of market-timing," said Louis Harvey, president of Dalbar Inc., a Boston-based mutual fund consulting firm. "It really hurts the fund companies -- almost without exception they have procedures in place to detect and prevent such activity." Harvey explained that "a holder may see that the U.S. market went down today, so he'll think the Asian markets will likely go up tomorrow, so he flips to an Asian fund to capture those gains."
Ira Cohen, VP of Operations for the AIM Funds, can quantify this phenomena. "We noticed a significant increase in market-timing dating back 18 months. Prior to that, our policy was that we reserved the right to refuse any purchase and the right to deny exchanges if we suspected there was timing going on. Then we inserted specific language to our prospectus -- limiting each shareholder to ten trades per year." Cohen noted that since that time, "the market-timing community got the message and they've been leaving our family of funds -- we have redeemed about $1.3-billion in assets from these timers."
"We do track such activity -- a big move in the U.S. markets is sometimes followed by a similarly big move in foreign markets and some short-term traders seek to take advantage of this phenomenon," said Steve Norwitz, a spokesman for the T. Rowe Price fund family. "If we notice any such obvious behavior, we may contact the shareholder and even seek to nullify such trades." Norwitz noted, however, "these are isolated cases, we haven't had a real problem with it at T. Rowe Price."
Jessica Catino, a spokeswoman for Fidelity Funds, commented "we strongly discourage market-timing in our mutual funds primarily by imposing short-term trading fees, which vary from fund to fund. In addition, most of our funds limit the number of exchanges allowable in a year to four -- that is, we permit just four `round-trips' in and out of one fund." Catino noted that as of the end of 2000, 84 of Fidelity's 164 retail mutual funds carried redemption fees.
Harvey noted that while such arbitrage "is not illegal, per se, most fund complexes have rules in their prospectuses which limit the number of times a shareholder can make these exchanges from fund to fund in a given year. In some instances, shareholders who violate these restrictions would probably be compelled by the fund company to redeem their shares."
Cohen noted that while AIM restricts its fund-holders to ten trades per year, "there is yet no industry-standard. Some fund complexes impose a one-trade-per-quarter limit, but most fund complexes do not have an established policy."
Who are these daring market-timers? Cohen says they come in all shapes and sizes, and they are not at all shy about who they are and what their intentions are. "Many of these timers are high-net-worth individual retail investors," he said. "There are also market-timing firms which identify themselves as such, and there are brokers who move their clients' money on an almost-daily basis. I've talked to many of these timers and they're quite explicit and clear about what they want -- they seek to take advantage of a highly volatile market, and they're not the least bit concerned about long-term performance."
Some have suggested raising redemption fees to thwart market-timers; but this may not work, and some believe it may not be fair to everyone. Harvey noted that slapping a higher redemption fee "would only punish the millions of innocent shareholders who are not market-timing." AIM's Cohen stated that "higher fees will not deter market-timers; quite frankly, it's meaningless to them. They feel that they know what certain markets will do, and they'll aggressively move their money to wherever they expect a large short-term gain, whether it be a fixed-income product or, as is often the case, a foreign equity fund."
Harvey added that the incidence of arbitrage and market-timing is "more likely to happen in the kind of weak and volatile markets we have been enduring recently. During the five-year bull market we enjoyed up until 2000, fund-holders were confident to maintain their money in their funds without jumping around." Cohen concurs, "a volatile market is the ripest environment for these market-timers. And it's very detrimental to our long-term stockholders. More and more fund companies, as well as the SEC, are beginning to seriously examine this issue."
Ghosh writes about mutual funds for Standard & Poor's FundAdvisor