December 21, 2004

Fund companies settle
Restitution payments half of losses

The Ontario Securities Commission reached settlement agreements with four mutual fund companies over the frequently reported market timing of big investors exploiting stale prices of overseas funds sold in Canada. While the restitution is significant, and losses to investors small; I am left with a pit of disappointment in my stomach.

The settlements

AGF Funds Inc., AIC Limited, CI Mutual Funds, and I.G. Investment Management Inc. settled with the Ontario Securities Commission for failing to design and implement adequate policies to discourage market timers from using its products for frequent trading. In aggregate, market timers and other short-term traders realized $301.1 million in profits. Gross management fees charged by the above firms totalled $17.3 million (before paying operating costs and trailer fees). Total restitution payments in the above settlements came to $156.5 million.

In addition, the broker/dealer arms of Bank of Montreal, RBC Royal Bank of Canada, TD Bank, and IGM Financial were also fined an aggregate $46.7 million for facilitating - and in some cases, promoting and encouraging - frequent trading by large investors. This amount is made up of a repayment of revenues (to investors) earned from market timing, an equal amount paid as a penalty to regulators, and $50k per firm for investigation costs.

Analysis

The silver linings are threefold. First, the settlement sums are substantial in absolute terms. Second, all of the $156.5 million OSC settlements are earmarked for investors harmed by frequent traders. Third, both U.S. and Canadian market timing investigations have put an end to market timing, created a deterrent for all fund companies in the future, and resulted in much tighter policies to ensure no such activity returns to funds.

Finally, the onslaught of market timing investigations pretty much scared away the large institutions that were trading in U.S. and Canadian funds. This article from TheStreet.com touches on a few of the names involved.

With the vast majority of the frequent trading concentrated in foreign funds, it's worth putting the above figures in that context. With about $80 billion in foreign stock funds today, the $144.6 million in net losses (that's $301.1M in total profits, less the $156.5M in restitution) totals just 0.18% of total foreign stock fund assets.

However, since a relatively small number of bigger funds were involved, the percentage of the affected funds (and investors) is surely a fair bit larger. Still, this loss was incurred over a period of two to four years.

Finally, it's worth noting that each settlement made a point of highlighting that not all profits were related to the exploitation of stale overseas prices. However, it's also worth asking why regulators did not take a closer look at this when both Transamerica and Standard Life had employees trading based on stale prices back in 2000.

Bottom line

Profits by frequent traders were more than double the restitution payments. And, the disappointing conclusion is that fund investors are out of pocket at the end of the day. The industry may downplay this angle given the relatively small proportionate amounts involved. However, for an industry built on trust, the amount is immaterial.

The fact is that mutual fund companies and dealers knowingly allowed and facilitated activity that directly pulled money out of the pockets of its end clients. It's a matter of ethics and principles, regardless of the amounts involved.

While we're all glad to see this issue come to a close, the ending is rather disappointing in that the industry has not stepped up to fully compensate its clients for losses sustained at the hand of the very wealthy. And the industry wonders why distrust is growing.