MUTUAL FUNDS – THE BLAME GAME

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
October 28, 2003

IN THIS ISSUE:

1. More Funds Cited For Illegal Practices.

2. Additional Funds Allowed “Late Trading.”

3. “Market Timing” Gets A Bad Rap.

4. Funds Want New Fees If You Sell Early.

5. Conclusions

Introduction

Mutual funds have continued to receive negative publicity in recent weeks as more and more fund families have admitted to allowing so-called “late trading” (after-hours trading) and what regulators and the fund industry have chosen to call “market timing.” As usual, there is a great deal of misinformation out there on these issues, and everyone who is in the crosshairs is looking for someone else to blame.

The truth is, there have been mutual fund families that allowed certain large investors to make selective trades after hours (ie – late trading), as alleged by New York Attorney General Eliot Spitzer. And there have been certain large investors who have abused the mutual fund trade processing system - with or without the funds’ knowledge - to their benefit and at the expense of long-term fund shareholders. Both the fund families that have knowingly allowed this practice, and the investors who participated, should be punished.

As for all the hoopla about “market timing,” you need to understand what is – and what isn’t – market timing, in the traditional sense of this investment term. You also need to know why the mutual fund industry is using this opportunity to bash market timing to their benefit, even to the point of adding new fees and charges for early redemptions.

I first addressed this issue in my September 16 E-Letter, but with all the publicity since then, it deserves additional clarification. If you invest in mutual funds, this is information you need to know.

Illegal Late Trading Of Mutual Funds

The “late trading” scandal first made news on September 3 when NY Attorney General Eliot Spitzer announced a $30 million settlement with Canary Capital Partners (CCP), a large hedge fund. Spitzer alleged that CCP had been entering dual orders – both to buy and sell – shares of various mutual funds on various days. On certain days when important news was announced after the markets closed, CCP allegedly was allowed to cancel one of the orders – either to buy or to sell – so as to take advantage of the news and the likely impact on the markets the following day. This is clearly illegal.

Since that time, certain other fund families have been named as allegedly allowing similar after-hours trading practices by some of their large investors. Again, the mutual funds found to have allowed this activity and the investors involved should be fined and disciplined.

However, to hear the media spin it, you would think that virtually all mutual fund families have allowed this illegal activity to go on. As a result, some investors are thinking about giving up on mutual fund investments altogether, which I think is a bad idea. I will explain why below.

There’s an old idiom that goes, “don’t throw the baby out with the bath water,” meaning that you shouldn’t throw something good away along with the bad. In regard to mutual funds, this means that you shouldn’t give up on this very beneficial form of investing just because there are a few bad apples in the bunch.

In the Special Articles below, I have a link to an article by Chuck Jaffe on CBS MarketWatch that discusses the anger being expressed by fund shareholders, but also why mutual funds continue to be the best choice for most investors. I definitely agree with his main point that mutual fund investing beats trying to pick individual stocks on your own, at least for most of us.

I learned long ago that my financial future was better off in the hands of professional money managers, so that’s where my money is and that’s where I recommend my clients invest. However, you shouldn’t invest your money indiscriminately. You have to check out the managers and fund families you invest with, or have professionals do it for you.

When all the investigations are done, I expect there will only be a relatively small number of mutual fund firms that actually allowed such illegal trading. After disciplining these bad seeds, I foresee the mutual fund industry coming out stronger than ever before.

A Poor Choice Of Words

When Eliot Spitzer announced his surprising findings and the large initial settlement on September 3, he chose to describe the rapid-fire, late trading activity of CCP and others as “market timing.” As I will discuss below, Spitzer’s choice of words inadvertently cast a shadow over the industry of money managers collectively known as active or tactical asset allocators, also known as market timers. Generally speaking, these money managers are not short-term traders (more on this below).

Investors who make these very short-term, rapid-fire trades – often in one day and out the next, as well as day-trading – can cause the funds’ transaction fees and related expenses to rise. If large blocks of money move in and out of the funds on a very short-term basis, this can also cause the fund managers to buy or sell securities when they would have otherwise not done so. This is why many mutual funds include specific language in their prospectuses which prohibits such short-term trading.

Unfortunately, some fund families allowed such short-term trading only for a select group of large traders, either as a way to keep their business, or in some cases, for compensation. You may recall that Eliot Spitzer alleged that Bank of America made an extra $2.25 million per year from these large investors and hedge funds in special payments and other incentives.

As noted above, the firms that allowed such transactions, when their prospectuses prohibited it, should be fined. That appears to be happening.

Traditional Market Timing Gets A Bad Rap

If you are one of my clients, or if you have read this weekly E-Letter for long, you know that I am a big proponent of traditional market timing as a defensive investment strategy. My company is constantly searching the globe for money managers who have been successful at being in the markets during upward trends, but who also have been successful in getting out of the markets during part or most of the downward trends.

The important thing to note is that the money managers we recommend are NOT short-term, rapid-fire traders or day traders. In fact, most of the money managers we recommend average only a few trades per year.

Additionally, traditional market timers manage less than 1% of the assets in mutual funds today. Even if they were all short-term traders, they would have a negligible effect on the funds and their long-term shareholders. Actually, most market timers who do short-term trading use the Rydex Funds or ProFunds or other funds like them that were specifically designed for and cater to short-term traders.

In short, traditional market timing has little or no impact on the mutual fund industry, but offers significant potential benefits to investors who use this strategy. Yet you would not think that if you listen to the financial media in recent weeks.

Why The Bad Rap Continues

The truth is that Eliot Spitzer gave the mutual fund industry a wonderful present when he called the short-term trades used to make good on illegal late trading “market timing.” Why? Because the financial press and the mutual fund companies WANT the public to take a dim view of market timing. For years, the Wall Street mantra has been “buy-and-hold.” They want you to put your money in their mutual funds and never sell.

Buy-and-hold means that you will enjoy the times when the markets are rising. But you will also lose money when the markets go down. The S&P 500 plunged over 44% in the 2000-2002 bear market. Many equity mutual funds lost that much or even more.

Yet the mutual fund industry wants you to buy-and-hold forever. This is why they have jumped on Eliot Spitzer’s characterization of illegal trading as “market timing.” They are all too happy to have the public believe that traditional market timing is a bad thing.

Funds Want To Charge Hefty Redemption Fees

Some mutual fund families are proposing to charge additional fees for investors who trade frequently. Some fund families are considering charging a fee of 2-3% for investors who sell prior to a required holding period. Some funds are considering the charge if you sell within the first 30 days after purchase. Others are considering even longer “lock-up” periods including 60 days and even 90 days.

I happen to think this whole idea is ridiculous! First of all, one of the most attractive features of mutual funds is that they are highly liquid. In most cases, investors may redeem on any given day they choose. New fees would encumber that. Second, it is a widely known fact that most investors do not read prospectuses. If these early redemption fees go into place, there will undoubtedly be investors who sell prior to the required holding period – and be charged the fee – without even knowing it existed.

More importantly, the mutual fund families generally know who their short-term traders are, especially the larger ones. They have software that identifies frequent traders. If they don’t want such investors, they can just kick them out. This happens fairly frequently already, so the funds don’t need these additional fees.

Hopefully, these new fees, if they are implemented, will actually backfire on the fund families. Investors may shun these funds. Existing shareholders may choose to move elsewhere. Time will tell.

Conclusions

As more mutual funds are cited for illegal late trading and/or allowing short-term, rapid-fire trading when their prospectuses prohibit it, you can expect to see more negative press regarding market timing. Keep in mind that the mutual fund industry and the financial media want you to think negatively about true market timing, since they make more money if everyone would simply buy-and-hold.

Also, keep in mind that the rapid-fire trading they are referring to is not what traditional market timing is all about. Not all traditional market timers trade frequently. Some make only a few trades each year. Most professional market timers who do trade frequently use the Rydex Funds or ProFunds which were specifically designed for frequent trading.

As noted above, I believe that all of the fund families who have allowed illegal trading should be fined and disciplined. Likewise, those who have allowed and/or encouraged short-term, rapid-fire trading – in violation of their prospectuses – should also be disciplined. That appears to be happening.

I do not believe the answer is for fund families to impose new early redemption fees as a way to curb short-term trading of their funds. If they don’t want it, they should simply kick out the short-term traders. Most of them have already gone to Rydex or ProFunds anyway.

And one last point. This article comes across pretty negative regarding mutual funds. But for the record, I am still a huge fan of mutual funds. While some are being fined and/or disciplined, these problems can, and very likely will, be fixed.

Mutual funds are still the hands-down best choice for smaller investors, allowing a level of diversification and professional management they can’t achieve on their own.

Whether you are a buy-and-hold investor, or a market timing investor – or both, as I am – mutual funds (carefully selected, of course) remain an excellent investment vehicle.

Best wishes,

Gary D. Halbert

SPECIAL ARTICLES

Why Keep Investing In Funds? (Free registration required.)

In Defense Of Market Timers (Free registration required.)