Online Extra: How Traders Play the Timing Game

Finance professor Jason Greene explains why this technique hurts buy-and-hold fund investors and how to protect yourself

In a complaint filed on Sept. 3, New York State Attorney General Eliot Spitzer contends that some of the mutual-fund industry's biggest names -- including Janus and Bank of America -- allowed a hedge fund to "time," or rapidly buy and sell, shares in some of their funds at outdated prices. Such short-term trading of fund shares isn't uncommon. Nor is it necessarily illegal. But it violates the internal policies many fund companies -- including those under investigation -- have in place to protect long-term shareholders.

Moreover, it costs buy-and-hold fund investors dearly, depriving them of about $1 billion a year in profits, says Jason Greene, an associate finance professor at Georgia State University's J. Mack Robinson College of Business. BusinessWeek Personal Finance Editor Anne Tergesen spoke with Greene about ways in which individual investors can protect their portfolios. Edited excerpts of their conversation follow:

Q: Why does "timing" penalize buy-and-hold fund investors?

A:

Say a fund has $100 million in assets when a trader intent on making a quick profit invests another $100 million. Now the fund has $200 million in assets. But because the fund manager can't invest the trader's $100 million immediately, only the $100 million originally in the fund is invested.

If that $100 million earns a 10% return the next day, the value of the fund's investment portfolio rises from $100 million to $110 million. But the shareholders already in the fund have to split the gains with the trader. So now, on assets of $200 million, the fund has gone up by $10 million -- which translates into a 5% return for shareholders, not the 10% return that shareholders already in the fund would have earned without the trader. It's a direct transfer from the shareholders to the traders.

Q: Is this common?

A:

Generally, most of the gaming occurs with international funds. There, it's fairly widespread.

Q: Explain how it's done.

A:

It's very well established that the U.S. stock market often leads foreign markets. So if the U.S. market has gone up, you can bet that foreign country indexes will go up as well by buying shares in foreign mutual funds at the end of the trading day in New York. You get to buy those international funds at outdated prices because they are priced at their home market's closing prices.

For example, Japan stops trading at 2 a.m. New York time. So the price of a Japan fund at the close of trading in New York does not reflect the news that came out in the U.S. that day. If the U.S. market rises, you would buy a Japan fund on the assumption that the Japanese market will move in tandem. If Japan rises, you earn a quick profit. Then, if the U.S. market falls, you would cash-out to avoid the subsequent down market in Japan.

Q: How can individual investors pick investments that offer some protection against these schemes?

A:

First, make sure you buy mutual funds with low expense ratios. That's a good indicator that a mutual-fund company is trying its best to look out for shareholder interests.

I also tell investors to look for funds that impose redemption fees, which discourage market timers. Of course, a fund that imposes redemption fees on individuals could strike a deal with a hedge fund to waive the fees.

Q: Which fund companies do you recommend?

A:

Vanguard, Fidelity, T. Rowe Price, and TIAA-CREF have been very active in addressing the problem of timing.

Q: Are there any other solutions?

A:

You can buy ETFs [exchange-traded funds]. They aren't susceptible to this problem to the degree the open-ended mutual funds are because the prices of ETFs change all day long. If you want to get international diversification, ETFs are a fine substitute for mutual funds.

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE