January 11, 2005

Afterthoughts on market timing
More questions than answers

After penning a recent overview of the OSC's investigation and settlements in the mutual fund market timing scandal, I reflected further on the whole situation. While many may be tired of hearing about this issue, there are important loose ends left by the OSC's recent investigation and string of settlements.

What about the others?

It is generally agreed among industry people and media outlets that many more mutual fund companies allowed market timing other than the five named publicly by the OSC. Settlements have been reached with four firms - AGF, AIC, CI Funds, and Investors Group - while Franklin Templeton Investments was named as the subject of an investigation after the other settlements were confirmed.

However, a June 21, 2004 Globe and Mail article suggested that AIM, Clarington, Dynamic, Elliott & Page, GGOF, HSBC, Mackenzie, R Funds, RBC, Scotia, MD Management, and Talvest also had various degrees of market timing in some funds between 2000 and 2003. It's important to highlight, however, that many of the funds listed in that article had and still have small asset levels. A fund with $20 million in assets is more likely to see a higher 'churn rate' than a fund that is $200 million or $2 billion in size. Hence, not all of the funds listed may have been 'market timed' but they may have missed others that had.

Obviously not all companies were pursued, which the OSC has all but confirmed. This January 2005 article by James Langton in Investment Executive states, in part:

"So, it seems not all the firms that consciously allowed market-timing have been caught in the OSC enforcement action. Indeed, the OSC acknowledges as much. 'Our purpose is not to punish all wrongdoers but to protect the market,' says Michael Watson, director of enforcement at the commission. 'We have sent a strong message to the industry with the settlements reached. In fact, the market-timing practices have stopped since we began our probe, and procedures are in place to detect and prevent them in the future'."

Perhaps the OSC has a point but investors in the fund companies that did allow rapid trading but won't be investigated don't feel all that protected. And if several fund companies involved in market timing were not pursued, it stands to reason that many involved MFDA dealers and IDA brokers also escaped the pursuits of their respective regulators.

Most puzzling is the fact that the OSC disregarded fund companies mentioned in the brokerage firm settlements. For instance, TD Waterhouse was penalized for facilitating rapid trading of its own TD Small Cap Equity fund and two of Frank Russell's Sovereign pooled funds (of which TDWH was one of just a few exclusive distributors). Seemingly, the 'facilitation' involved reducing or waiving short-term trading fees for a few large investors while continuing to go by the book and charging all of its smaller retail clients making similar trades.

Similarly, the RBC Dominion Securities settlement also confirms that some of the market timing trades it facilitated occurred in its related RBC fund family. But the respective mutual fund arms of RBC and TD were left alone.

What about 'money market' funds?

Interestingly, a key component of market timing activities has seemingly been ignored over the past couple of years - namely, money market funds. Recall that the traders that were rapidly trading in and out of funds were doing so by moving between a firm's money market fund and some of its foreign stock funds. It did this because switches between funds in the same 'family' - i.e. CI Money Market and CI International - settle on the same day the trade is submitted.

While all of the attention seems to be focussed on the losses such trading caused for stock funds, the impact of rapid trading on money market funds seems to have been forgotten. While resulting losses in money market funds probably pale in comparison to those suffered by foreign stock fund investors, the issue should not be cast aside.

Losses in money market funds would have resulted to the extent that the in and out trading forced the sale of treasury bills and other short term paper prior to maturity. As with all fixed income securities, there is an implicit cost known as the 'bid-ask' spread - i.e. the difference between the purchase and selling prices of money market instruments. Given the level of trading noted in the various settlement agreements, I estimate that a money market fund could have seen 500 round trips in a year from an institutional trader. Each trade was typically $1 million and up.

For retail investors, a round trip (i.e. buy and sell before maturity) on a 90-day Government of Canada treasury bill is something like 0.5% at a discount broker. Assuming that institutional pricing costs only 1/10th of that, it can get very costly for a money market fund manager to sell money market securities prior to maturity if rapid trading required heavy turnover at the fund level.

Interestingly, turnover figures are not published for money market funds but the information is available in the fund financial statements to calculate money market turnover rates.

While the OSC looks to have all but wrapped up its investigation with record fines in the spirit of protecting markets, there are many investors who are left with disappointment and fewer dollars in their mutual fund accounts. This is just the sort of situation that may spur otherwise 'too polite' Canadians to get into a litigious mood.