D&O/E&O – Is There Any Good News? Michael P. Morabito XL Professional - Hartford 2004 Casualty Loss Reserve Seminar Las Vegas, Nevada – September 13, 2004 Mutual Funds Under Scrutiny: Market Timing/Late Trading
Forward Pricing Rule – Rule 22c-1 of Investment Company Act of 1940
When a trader is permitted to place an order after 4:00 p.m. EST and have that order filled at that day’s NAV, that trader has engaged in late trading
Unlike market timing, late trading is illegal
SEC Survey of Mutual Fund Late Trading/Market Timing ¹
More than 25% of broker-dealers surveyed allowed customers to confirm or place orders after 4:00 p.m. EST
Almost 70% of broker-dealers reported being aware of timing activities by their customers
Documents provided by almost 30% of responding broker-dealers indicate that they assisted market timers in some way
50% of responding mutual fund groups appear to have had arrangements that allowed select customers to market time
¹ Cutler, Stephen (November 3, 2003). Testimony Concerning Recent Commission Activity To Combat Misconduct Relating to Mutual Funds . (Reporting on results of preliminary SEC survey of 34 broker-dealers and 88 mutual fund complexes)
Exhibit A Example of Market Timing Below is an example of the dilution effect of market timing from Yale professor of finance K. Geert Rouwenhorst, as set forth in Jeanne Sahadi’s September 4, 2003 article from CNN/Money entitled “How Scandal May Bilk Mom & Pop”: Say a mutual fund investing in European stocks has four long-term shareholders who each own one share. The fund’s net asset value per share (set once a day at the close of trade in New York) is $10 on Monday. So the total value of the fund is $40 ($10 per share x 4 shareholders). At 2 p.m. EST Monday, good news about various holdings in the fund comes out, news that is likely to push share prices higher by 25 percent when trading resumes in Europe Tuesday. But your fund’s NAV Monday doesn’t yet reflect this good news because it’s based on share prices at the close of European trade, which occurs several hours before Wall Street shuts down. The fund’s shareholders might expect their NAV to rise 25 percent on Tuesday to $12.50 a share. Then the fund’s total value would be $50 ($12.50 per share x 4 shareholders). But they’ll get less if a market timer or late trader steps in.
Exhibit A (Cont.) Example of Market Timing Here’s how: Say the trader senses prices will go up and decides to buy a share of the fund at Monday’s NAV of $10. Tuesday rolls around, and sure enough European prices rise and so does the fund’s NAV. With the trader’s late-day investment Monday plus the boost in share price, the fund’s total value comes to $60 ($50 after 25 percent rise in share price + $10 cash investment from the trader). With the trader, there are now five shareholders in the fund, so each fund share is now worth $12 ($60/5), instead of the $12.50 the four original shareholders were expecting. The trader will sell his share on Tuesday for $12, booking a $2 profit. That’s the equivalent of 50 cents a shareholder – which is the same amount forfeited by each of the original shareholders because of the trader’s actions. In other words, instead of getting the 25 percent increase in NAV they were expecting, the shareholders only see a 20 percent increase.