Round Two of Market Timing

By October 12, 2006, mutual fund companies have to comply with the Securities and Exchange Commission’s mutual fund redemption fee rule, Rule 22c-2. The rule, which is voluntary, has received much criticism from the Investment Company Institute (ICI), the mutual fund trade group, because it requires all funds, regardless of whether they impose a redemption fee, to draw up written contracts with every intermediary with which they do business.

The SEC hopes the rule will help funds recoup the costs that short-term trading can impose on funds and their long-term shareholders. Peter Delano, a senior analyst at TowerGroup, says the SEC also issued the rule so that funds could better keep track of what’s happening at intermediaries. But the ICI is up in arms because it says that some funds have relationships with tons of intermediaries, and it will require huge amounts of time–and money–for them to comply. Plus, the SEC has yet to clarify the definition of intermediary. Elizabeth Krentzman, the ICI’s general counsel, told the SEC in a comment letter that the rule also unfairly requires funds “to bear all of the responsibilities and liabilities associated with imposing redemption fees.” Krentzman wrote that the rule “is silent with respect to the obligations of intermediaries (including those maintaining omnibus accounts with a fund and being compensated by the fund for their recordkeeping activities) to impose, or facilitate the imposition of, redemption fees.”

In early October, the NASD fined three firms–ING Funds Distributor (IFD), First Allied Securities, Inc., and Janney Montgomery Scott–for market timing violations. ING Funds Distributors was fined $1.5 million, so far the largest fine NASD has imposed in a market timing case, for allowing market timing in its Pilgrim Funds. First Allied Securities of San Diego was fined $408,000 for facilitating the deceptive efforts of three hedge fund customers to engage in improper market timing, according to NASD. Janney Montgomery Scott, based in Philadelphia, was fined $1.2 million for improper market timing and related violations, which included “allowing two hedge fund customers to evade attempts by mutual fund companies to block or restrict their market timing transactions,” according to NASD. In settling each matter, none of the firms admitted nor denied the NASD allegations, but consented to the NASD findings.

Delano addressed Rule 22c-2 in an August report called The SEC’s Response to Market Timing: Implications for the Mutual Fund Industry. I chatted with him recently about what the rule means for mutual funds and investment advisors.

Does the rule have a direct effect on investment advisors? While advisors are not directly affected, based on the structure of the mutual fund, it could be the case that within a complex [the fund company is] doing investment advisory services, distribution services, and transfer agency services, but there isn’t a direct link to the money management arm.

One thing that will affect advisors is the analysis of whether to use redemption fees. Fund boards would want their advisors to give them a sense of what market timing would mean to their portfolio strategies. How much cash do they have to have on hand? What types of securities are they trading? For instance, international funds tend to be more subject to market timing because of time-zone differences. So in the analysis of portfolios, in the sense that if a board decides to charge a 1% or 2% redemption fee for a certain holding period, what does that mean to the investment advisor?

At what stage are funds now in trying to comply? They are in that first phase of trying to figure out who their intermediaries are based on this ruling and how to enter into agreements with them. They are still waiting for SEC guidance–right now the intermediary definition is still broad. Intermediaries could mean retirement plans, bank trust departments, any situation where there is one account that may be held for multiple individuals within that account.