"Market timers are like Las Vegas card counters.... In Las Vegas, card counters profit at the expense of the house. In mutual funds, the other players own the house."
Hard on the heels of the Enron saga, mutual funds have come under scrutiny from the New York attorney general, the Securities and Exchange Commission and—to make a prediction—probably from Congress any time now. Just as predictably, the media pack has chased right behind the politicians. Everyone calls for action to redress the "scandal" of market timing in funds.
It is hardly surprising that various government entities want a piece of the mutual-fund political action, nor that the media are salivating over it all. The more interesting issues are two. First, what exactly is the problem that is garnering so much press and tube attention? And second, is there something useful for government to do here?
To understand the problem, for starters, a little institutional background is required.
How Mutual Funds Work
Mutual funds perform several functions for investors, and do so through different kinds of funds. Specialized (e.g., high-tech, energy-company) funds research opportunities for investors, and invest in specific sectors accordingly. Index funds hold a diversified portfolio of different stocks that replicates the entire equity market rather than particular sectors. To achieve greater diversification, funds may also hold varying amounts of bonds and short-term (money-market, Treasury) instruments as well. Literally thousands of different funds mix and match the assets they hold, so as to offer a range of choices to investors seeking different investment opportunities at relatively low costs of assembling the desired portfolio.
But the funds are all alike in several fundamental respects. Every fund is owned by its shareholders, who are also its investors. Mutual funds are a sort of holding company, owning the securities of other firms. And so, the value of mutual funds depends on the value of the underlying firms whose securities they hold. And there begins the story of the current mutual-fund "scandal."
Unlike many of the securities that they own, mutual funds ordinarily do not trade on public exchanges. But of course, investors choose funds in which to invest on the basis of the funds' present and expected future value, so the funds' shares must be valued in some way. Typically, American mutual funds have reckoned their value (the price at which their shareholder-investors can buy and sell shares) once a day, often in the late afternoon, after trading in the securities the funds own has ended on the major American exchanges. This "net asset value" (or "nav") is the fund share price we see reported daily in the financial press.
A second institutional aspect of mutual funds is important to the scandal story. Owner-investors pay a fee to the fund for the investment management that it does, just as any investor pays his broker for research, trading and related tasks. Those fees are a matter of record and easily obtainable by investors. And they are important, because the fundamental appeal of mutual funds is their ability to do research, buy and sell shares, and construct desirable share portfolios more cheaply than Average Joe Investor could do all that for himself.
In fact, Average Joe ordinarily is investing in the mutual fund precisely because he does not want to do stock research and does not anticipate large amounts of buying and selling. He is investing for the long haul—his retirement, his children's college education and so forth. Because the fund can anticipate that he is putting his money in for the long haul, with little trading in and out, the fund will charge Joe a low fee for managing his investments.
These basic elements make mutual funds an attractive proposition for their investor-owners. Because their investors are in the game for the long-term stakes, the fund need not worry as much about short-term swings in the prices of the underlying securities that the fund holds. These will even out over time. And for the same reason, the fund generally need not worry about sudden inflows and outflows of investor money.
But what if…? What if a relatively small group of investors realized that the institutional framework of mutual funds could be manipulated to their advantage. If mutual funds only price their shares once a day, late in the afternoon, events that occur after the market close and before the next day's opening will affect the value of the underlying securities owned by the fund. Someone then can study the value changes in the underlying securities, including price changes for foreign stocks and bonds owned by the fund that trade overseas, and anticipate the likely gains or losses in the fund's "nav" the next day. (Needless to say, computers make that scenario much easier than it would have been twenty, even ten, years ago.) Figuring out prices in advance in turn creates opportunities for short-term traders to time their moves, moving into and out of mutual funds to their profit ahead of the once-a-day price revisions.
And so, short-term trading (so-called "market timing") began to occur in mutual funds owned mostly by long-term investors. To an economist, this is certainly unsurprising. Profit opportunities rarely go unexploited—almost never in sophisticated capital markets. Arbitrage to take advantage of value differences is an essential and desirable aspect of free markets, moving resources to higher-valued uses.
But market timing is more complicated than it seems at first. It allows some fund investors (the small number of short-termers) to take advantage of the others (the large majority of long-term investors). If short-term investors are moving into and out of funds mostly owned by long-term investors, fund trading costs increase, hurting the majority of investor-owners who are not market timers.
The majority, long-term investors lose in at least two ways. First, the transaction costs of the funds naturally rise, because short-term trading increases the number of transactions. In addition, a rise in short-term trading may require the fund to shift its investment strategy, holding more cash or liquid instruments to ensure it can meet frequent liquidity demands from short-term sellers.
To use an imperfect analogy, market timers are like Las Vegas card counters. Unlike the other players at the blackjack table, they can reckon the odds on the next hand, and so will rake in more chips. The analogy is imperfect, though, because in Las Vegas card counters profit at the expense of the house. The other card players do not own the house, and so do not care about card counting. More power to you, pal.
In mutual funds, the other players own the house. Market timers thus may profit at the expense of the long-term investors, whose fees must rise as transactions cost rise and non-optimal amounts of liquidity are required. Peter is taking from Paul, when Paul invested on the understanding (often stated explicitly by the fund) that there would be no short-term traders like Peter. Market timing means a house is divided against itself.
The analogy is useful, though, as it focuses attention on the issue of true importance. In Las Vegas, as card counters reduce the value of the casino, the house makes card counting more difficult (by using multiple decks) or just expels the card counters. The house can look out for itself; no one proposes legal or political solutions to card counting. Is there some reason why mutual funds cannot solve their card counting problems themselves?
The Solutions: Private vs. Governmental
No. Admittedly, fund shareholders are poorly placed to solve any problems they face, and so may have to rely on others to straighten things out. Mutual funds differ from Las Vegas casinos because they are owned…mutually. As a mutual-fund investor, I own a piece of Fidelity, of Vanguard, and of Travelers Insurance. How much time and effort am I willing to devote to analyzing and solving the problems of the funds that I own? Even if I am among the majority group of long-term investors being penalized by the short-term market timers, are my losses large enough that, as one of millions of owners, I will spend any time trying to solve the problem?
Almost certainly not. The gains to the handful of market timers are significant to them, but my fractional share of the losses is trivial—certainly too small to motivate me to do anything about it. It does not necessarily follow, however, that outside governmental solutions are required.
The duty of policing mutual fund practices falls, in the first instance, to the fund's directors and officers, who care intensely about practices that lower the fund's value. Unlike shareholder-investors, fund management serves full-time, and has every financial incentive to maximize the value of the firm. One would predict therefore that the funds themselves, once the rise of market timing was discovered, would take steps to end it.
And so they have.
There are various ways to solve market timing problems. First, revising funds' pricing strategies can make market timing unprofitable. Some funds have moved to so-called "fair value" algorithms to update their prices in ways attempting to capture likely value changes after the close of the market.
In addition, the market timing problem can be solved by differential pricing. A fund may be willing to tolerate short-term trading, as long as market timers cover via higher fees the extra costs they impose. And so, some funds now impose a short-term "redemption fee" that covers additional costs (and also reduces potential profits from unwanted market timing).
Other correctives are being employed. Funds have fired or pressured resignations from those who broke the rules by encouraging market timing. Long-term investors in funds where problems have occurred have moved their investments elsewhere. Employers have dropped funds where alleged abuses occurred from the list of investment options available to employee 401(k) retirement plans.
It is important to note that—like card counting—market timing is perfectly legal. But in general funds do not want it, any more than casinos like card counting. Faced with their own private problems, funds are remedying them internally. The worry is that familiar one: politicians piling on to legislate even as funds and their investors are solving their own problems privately. Bad outcomes and unintended consequences almost certainly would follow.
The press divides its mutual-fund stories into two categories, but each refers essentially to the same phenomenon, stemming from the features of mutual funds just described. By "late trading," an investor can buy or sell fund shares after the afternoon price is established but before the fund is open for business the next day. By "market timing," investors can transact in fund shares the next day, while the fund is open for business but before the shares are re-priced. Of the two, late trading is less common and may be illegal. Market timing is apparently far more prevalent, and as noted below is not illegal.
How great the overall losses to the fund may be is unclear. Almost certainly, given the relatively small number of market timers relative to long-term investors, the losses per capita would be minimal.
Fred S. McChesney
is Class of 1967 / James B. Haddad Professor, Law School, and Professor, Department of Management & Strategy, Kellogg School of Management, Northwestern University. His email address is f-mcchesneylaw.northwestern.edu
For more articles by Fred S. McChesney, see the Archive.