A Distinct Chill Has Descended On Market Timing Relationships
Mutual funds and issuers of variable insurance products have been grappling with the adverse effects of market timers for several years.
In the past, the responses have been tempered by the love-hate relationship between funds and insurance products issuers on the one hand and market timers on the other.
However, a variety of forces have now upset the balance so that a distinct chill, if not hate, has descended. What is this about, and whats being done about it?
To many fund managers, market timers’ adverse impact on performance now outweighs their asset gathering benefits. Thats because frequent short-term trading boosts the funds’ transaction costs and requires fund managers to keep more cash uninvested to meet redemptions. If they dont keep enough cash on hand for redemptions, they may be forced to sell holdings at times and at prices that adversely affect performance.
An additional negative effect is the increase in the tax liability of shareholders. A funds sale of appreciated stock results in capital gains taxable to shareholders, even if the holders have not sold their fund shares or if the funds’ current price is lower than the purchase price.
The ill effects of market timing are felt most by international funds. Thats because market timers have been engaging in what is known as “time zone arbitrage.”
Here, the timers bet, with some degree of success, that overseas markets will respond favorably to a rise in markets in the United States. The timers buy a mutual fund that invests in foreign stocks, expecting those stock prices will rise based on an upswing in the U.S. markets. They also dispose of the funds in anticipation of a downturn in the foreign markets and related stocks the fund holds.
Other mutual funds, including municipal bond funds, have also felt victimized by more traditional market timing activities.
In the past, mutual funds responded in tempered ways to short-term trading by market timers. Positive performance in the bull market of the 1990s was readily achievable, the markets were less volatile, globalization of the markets was a buzz phrase and less of a reality, and timers had not thought of this gambit.
Fund families and variable insurers responded by monitoring and identifying market timers and dealing with them individually. Some also limited the right to buy back into the fund following a short-term purchase and sale.
Those techniques have proven to be costly. So, in the last 18 months, a marked trend toward imposing redemption fees has emerged as the favored solution. By March 2001, a recent study says, about 600 funds had implemented such fees, up from roughly 300 funds 18 months ago. Even so, the verdict is not yet in on the overall benefit of redemption fees.
Under the Investment Company Act of 1940, mutual fund redemption fees cannot exceed 2%. Some observers think that is not high enough to curb short-term trading.
Fund families have been experimenting with other permissible aspects of redemption fees, such as the time span that activates the fee. One major fund family imposes the fee if the investor redeems shares within 90 days; another if the round-trip occurs within 30 days; and yet another has fee breakpoints, charging the full 2% for shorter transaction periods and 1% for longer ones.
It is interesting to look at how the staff of the Securities and Exchange Commission has responded to the industrys efforts.
While a core concept of the 1940 Act is redeemability, the SEC staff has been sensitive to the adverse impact timers may have on long-term investors. The staff also appears to be pacified by the fact that, as opposed to deferred sales charges, redemption fees go into fund assets and, hence, to shareholders, not into the pockets of distributors or fund managers.
The SEC staff continues to make statements that they are looking at the issues. However, to date, they have not taken any action to assist or curtail funds in their efforts to restrict market timer activities. The staff appears caught between the core principle of not restricting redeemability and its recognition that market timing may harm long-term shareholders.
Meanwhile, the SEC has become more liberal in its review of the practices of insurance products issuers, permitting them to limit transfers between separate account subaccounts, provided the limitations are designed to protect the remaining investors.
Where this trend will take the mutual funds and variable insurers is still unclear. While fund firms may feel theyre getting results, they are concerned about driving active investors away from mutual fund investing and into the arms of the fast-growing competition–folio products and exchange traded funds.
Variable insurers have promoted the tax-free asset rebalancing of investments under their contracts. Investment advisors, including market timers, have been a growing source of sales of such products–in part, because of the tax-free transfers between investment alternatives. But, while one insurer has recently chosen to limit the permissible number of same-day transfers, another has designed a product thats friendly to timers.
So the love-hate relationship continues, with independent investment advisors playing a greater role in shaping events.
Joan E. Boros, Esq., is a partner in the Jorden Burt LLP law firm of Washington, D.C. She can be e-mailed at
Reproduced from National Underwriter Life & Health/Financial Services Edition, August 20, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.