When Market Timers Target Funds
By Amey Stone
Market timing has always sounded good in theory but been virtually impossible in practice. Even though timing strategies have inspired legions of investors and prompted millions of trades, academics unequivocally dismiss them, insisting that anyone who claims to make money at it is either lying or just lucky.
Except in the world of mutual funds. There, traders in the know have long been profiting from a strategy that involves moving in or out of funds on volatile days in an effort to take advantage of pricing errors. These errors crop up because funds are priced once a day based on the most recent prices of the underlying securities they hold, some (or all) of which might not have actually traded for hours before that.
WINDOW TO THE FUTURE.
Most often in such arbitrage plays, traders take advantage of stale prices in international funds. They're usually priced at 4 p.m. Eastern Time -- even though the underlying securities may have last traded far earlier (for example, Tokyo's exchange closes at 2 a.m. ET). So the trader is essentially buying the stocks in the fund at prices that were updated hours earlier.
Here's where the opportunity comes in: Since international bourses follow U.S. ones about 75% of the time, odds are that when the latter surge upward, if a trader buys an international fund late in the day in the U.S., it will score a big jump in overnight trading overseas. When U.S. markets drop (as they often do right after a day of big gains), the traders then sell the fund. Again, the odds are on their side that they're getting out before the foreign markets decline.
"You don't have to look into the future to time mutual funds," says Roger Edelen, an assistant professor of finance at the University of Pennsylvania's Wharton School whose research shows such arbitrage opportunities exist among domestic as well as international funds. "You can look backwards because the funds are late."
This kind of market timing is something that mutual-fund investors should care about -- not because it's a strategy worth trying yourself, but because these traders' profits come directly at the expense of long-term investors in the funds they target (see BW Online, 12/11/02, "How Arbs Can Burn Fund Investors"). "The traders are buying discounted shares at the [expense] of the other shareholders," says J. Alan Reid, president of Forward Funds. "They're literally eating out of the pockets of other shareholders."
This problem seems to be getting worse. That's because traders stand to make more from this practice in volatile markets -- and 2002 has been particularly rocky. In an October, 2002, working paper, Eric Zitzewitz of the Stanford Graduate School of Business found that from 1998 to 2001, investors could have earned a potential annual return of 35% to 70% using this strategy in international funds, about twice as much as they could have made from 1992 to 1996.
A study by FT Interactive Data (which launched a service to provide more timely prices to funds last August) found that in July, 2002, alone, the strategy would have earned 12% (or 146% annualized).
SMALL AND VULNERABLE.
More arbitrageurs mean long-term investors are losing more money. Zitzewitz' research found that the resulting shareholder dilution has risen from 0.5% in 1999 (that was the finding of Jason Greene, an associate professor of finance at Georgia State University's Robinson College of Business) to 1.14% in 2001. Add the costs of executing the trades, and a fund that would have gained a hypothetical 10% would return only 8.15% -- thanks to the traders.
Some funds are hit much worse than that, and small ones can be particularly vulnerable to large swings in cash flows. "They would come in with $5 million in a day in a $20 million fund and sweep out five days later," says Reid, who added a redemption fee to his fund to discourage traders when he became aware of the practice.
It's paramount for investors, especially in international funds, to make sure their fund company has policies in place to deter arbitrageurs, says Mercer Bullard, chief executive of Fund Democracy, a shareholder advocacy group. Check the prospectus for rules that allow the outfit to kick out active traders, impose redemption fees, set prices early (Rydex prices some funds in the morning), or delay moves from one fund to another by a day (on November 13, 2002, the Securities & Exchange Commission issued new guidance to fund companies that allows them to delay exchange requests).
Best of all, say academics, the funds should have provisions for what's known as "fair-value pricing." Sophisticated methodologies are used to adjust the fund's closing prices to reflect market events that have occurred since the underlying securities last traded. Fair-value pricing eliminates arbitrage opportunities, while other methods to deter trading are "indirect" and can be overcome, says Bullard. For example, funds often can't impose redemption fees in 401(k) plans, no-fee fund supermarkets offered by brokerages, insurance products, or any accounts where orders are pooled before they're sent on to the mutual-fund company.
Some funds resist using fair-value pricing partly because they feel it borders on "subjective" pricing and could expose them to legal risk. But an April, 2001, SEC ruling found that funds are obligated to use fair-value pricing following "significant events" that weren't reflected in closing prices. "The letter makes it pretty clear what our obligations are," says Joe Carrier, treasurer and chief financial officer of T. Rowe Price funds. Carrier says the company has "fair valued" shares 40 or 50 times this year. But he thinks some firms are still playing catch-up on this issue and find implementing fair-value pricing somewhat "daunting."
For investors, it's key to stay out of funds that aren't being aggressive about thwarting arbitrageurs. Many are doing their best, but the funds that are most aggressive about implementing policies that discourage trading are typically those with low expense ratios and more outsiders on their boards, Zitzewitz finds.
"NUCLEAR WINTER" SCENARIO.
"The real risk is as more and more companies defend against this, traders are focusing their efforts on a smaller number of funds that could get caught in a vicious cycle," says Bullard. In a scenario he calls "nuclear winter," a particularly hard-hit fund could actually go belly-up if it's caught in a downward spiral where it has to redeem shares at an inflated price and then raise cash by selling securities into an illiquid market that's plunging.
That hasn't happened yet. But fund investors are already losing up to $5 billion a year to arbitrageurs, Zitzewitz estimates. (Greene's 1999 estimate was a total of $1 billion lost.) "Over the past two years, we've all come to know that there's this problem out there," says Wharton's Edelen. "What's shocking is that we can't seem to really solve it." As with so much in investing, for the average participant, the best defense is buyer beware.
Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column
Edited by Patricia O'Connell