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By Gary D. Halbert
February 17, 2004


1.  Where We Are Now In The Mutual Fund Scandal.

2.  Enforcement, Not Market Timing, Is The Problem.

3.  Mutual Fund Industry’s Proposals Are Bad News!

4.  We Don’t Need New Rules, Enforce The Old Ones.


This week, we will revisit the recent mutual fund scandals and more importantly, some of the so-called “remedies” now being proposed by the SEC and Congress.  Sadly, some of these new proposals have the potential to HARM INVESTORS more than punish the mutual fund families who have been guilty of abuses.

The investigations into mutual fund families that allowed illegal after-hours trading and other abuses in their funds continue to widen, although you may not have heard much about it in the press.  As of late January, at least 20 fund families were being investigated. 

The regulators at the SEC are working overtime to come up with ways to prevent these abuses.  Several groups within Congress are also racing to pass new legislation, all in the name of protecting investors.  Yet powerful lobbies for the mutual fund industry and the brokerage community are seeking to take lemons and make lemonade.  To a certain extent, they have already been successful, as I will discuss below.

The bottom line: these new remedies will very likely result in higher fees paid by mutual fund investors; require holding periods for funds, with penalties should you have to withdraw money early from a fund due to an emergency; and in the end, line the pockets of the mutual fund industry.

The Anatomy Of A Scandal

Just to recap, last September New York Attorney General Elliot Spitzer shocked the investment world when he named several well-known mutual fund families in a complaint for “late trading” and improper “market timing.”   On the late trading issue, these funds were allowing large customers (mostly hedge funds) to make trades after the day’s results were known.   In essence, it was almost like betting on a horse race after it had already been run.

The market timing issue, which was mis-named from the start, is more complex as I discussed at length in my October 28, 2003 E-Letter ( CLICK HERE).  What Mr. Spitzer inadvertently referred to as market timing is actually known as “international arbitrage” or “time zone arbitrage.”   Here is a quick summary of how it works. 

International mutual funds sponsored by US firms hold foreign stocks that are traded on foreign exchanges.  These foreign markets open and close at different times around the world and in some cases, the time zone differential can be up to 12 hours.  The Asian stock markets, for example, close during the night in America, well before US stock exchanges open in the morning.  News can occur after the Asian markets close that can significantly affect their share prices, up or down, the following trading day.

Traders who monitor such news can purchase US mutual funds that they know hold the affected stocks in Asia, anticipating that the price of the US fund will go higher.  For example, let’s say the Asian markets close on a Tuesday night in the US, but news comes out after the close that should make those share prices move higher the following day.

A trader could then, on Wednesday, buy US mutual funds that he knows holds those stocks which will be affected by the news.  The Asian markets adjust higher to the news on Wednesday, after our markets have closed.  US mutual funds react higher as well, but on Thursday.  Then the trader sells.  He buys one day and sells the next, often reaping a nice profit.

It is important to note that international arbitrage is not currently illegal.  The mutual funds got in trouble when they allowed insiders and large clients to make short-term international arbitrage trades, even though their fund prospectuses prohibited them. 

Enforcement Is The Problem, Not Market Timing

So is this “market timing?”  It is in an international sense, and to the degree that it results in a lot of short-term trading in these types of mutual funds.  However, this international fund arbitrage is in no way similar to the traditional market timing strategies which have been practiced by investment professionals for decades.

Now here’s why this is an enforcement problem.  Many mutual funds have a written policy that prohibits short-term trades.  Some funds even impose an early redemption fee for doing so.  However, in the mutual fund scandal, some funds chose to ignore this short-term arbitrage trading by insiders and large, preferred customers.  They were not charged the early redemption fees, even though regular customers of the fund were subject to these fees. 

The problem was not that there were no rules in place, or that the funds didn’t know about the short-term trades.  The funds simply chose not to enforce the rules for certain investors because it was a profitable business for them.  Sorry folks, that’s not market timing - it’s illegal – and the funds are now in trouble for it.

As I have written before, it is unfortunate that Mr. Spitzer used the wrong term – market timing - to describe the short-term trades that the crooks used to make good on their late-trading and arbitrage opportunities.  Yet the financial press and mutual fund industry have picked up the term and made it equal to something illegal, and this was not by accident.  This is how the industry is trying to take lemons and make lemonade.

The Inside Story On Market Timing

As noted above, the traditional market timing industry has been around for a long time.  What you may not know is that professional managers who practice traditional market timing strategies with mutual funds are generally disliked by the mutual fund industry. There are several reasons for this. 

For years, most mutual fund families and brokerage firms have preached that investors should simply “buy-and-hold,” meaning that you buy their funds and hold them for a very long time. There’s a good reason for this.  The longer you stay in, the more money they make!  Any investment strategy that takes money away from them – as traditional market timing does periodically - must be bad.

For years, the fund families and brokerage firms trotted out arguments about how market timing doesn’t work, even though many of those arguments were flawed, as I discussed in my September 16, 2003 issue of this E-Letter ( CLICK HERE).  However, when Mr. Spitzer used the term market timing to refer to the improper trading practices going on, the mutual fund industry jumped all over it!  Their friends in the financial press (who are also strong adherents to the buy-and-hold myth), readily ran stories that made market timing sound like something, if not illegal, at least highly unethical.

The Proposed Remedies – Look Out!

There’s nothing like a good scandal to wake up politicians as well as regulators.  Since Spitzer’s first announcement, both the SEC and Congress have proposed solutions to the mutual fund late trading and so-called market timing problems.  Unfortunately, some of these new proposals are almost as bad, if not worse, than the activities they seek to prevent.

One rule being proposed by the SEC, and also included in several of the bills in Congress, is a so-called “HARD CLOSE” at 4:00 PM Eastern Time.   Most investors don’t think much about this, since they know this is when the stock exchanges close.  However, it is less well known that mutual funds often continue to take trade information, including orders to buy and sell, from intermediaries (such as 401(k) administrators and mutual fund supermarkets) well after the 4:00 PM close.  In fact, some 401(k) transactions are not transmitted until the following morning.

A 4:00 PM hard close would require all orders to be received by the mutual funds by the time the exchanges close – no exceptions.  On the face of it, this rule sounds good – if everyone has to get their orders in by 4:00 PM, then there’s no opportunity for late trading abuses.  Yet in practicality, this rule will be very ONEROUS. 

As it stands now, you can call most mutual fund companies by 4:00 PM and place a trade.  However, if we go to a hard close, all fund companies will have to implement an earlier cut-off time for orders to be placed through intermediaries.  Some families will go to a 3:00 PM cut-off, while others may be even earlier, say 2:00 PM.  That would mean that folks on the West Coast, for example, would have to place their orders by noon or even 11:00 AM PST!

While the hard close rule may sound reasonable, the net effect will be to push cut-off times for transactions earlier and earlier.  This will actually penalize investors by removing some of the flexibility they have in the timing of placing orders.

In short, everyone is penalized for the actions of a few!

Mandatory 2% Early Redemption Fee

Another proposal being floated both by the SEC and Congress is a mandatory early redemption fee of at least 2% if a fund is redeemed within a short period of time (usually 5 days).  Guess who loves this idea?  The mutual fund families and the brokerage community, of course!

The mutual fund industry is extremely competitive, and the trend for many years has been toward lower fees.  Investors have demanded it.  As a result, many mutual funds did not charge early redemption fees as it put them at a competitive disadvantage.  If you can put your money with one fund family and move it, if necessary, without a fee, then why would you want to invest with another family that charged such a fee? 

Some of the proposals before the SEC and Congress dictate that almost all funds charge such an early redemption fee, with very few exceptions.  Not surprisingly, the Investment Company Institute (ICI), a major mutual fund trade association, wholeheartedly supports the 2% fee proposal.

If the mutual fund lobby has its way, these funds will be able to charge early redemption fees and blame the SEC and Congress for making them do it.  Yeah, right.

There is another point to be made against the mandatory redemption fee.  Investors rarely read prospectuses, and many will not even know about the early redemption fee until it is too late.  There will be many investors who buy a fund but decide to change their minds a day or two later.   If this new proposal is adopted, these people and others won’t know they are getting hit with a 2% (or higher) fee until it’s already done.

Here again, everyone is penalized for the actions of a few!

They Need To Take Responsibility

Just to recap, the mutual fund industry is responsible for allowing corrupt practices that led to investor losses and legal action by the New York Attorney General.  The funds knew the large customers that made most of the illegal trades.  They could have enforced their own written policies and kicked them out.  But they didn’t because the business was highly profitable.

Yet not only does the industry refuse to take responsibility for its actions (or inactions), they now propose remedies that penalize everyone and will only serve to line their pockets with new fees.

A 4:00 PM hard close will only reduce investors’ flexibility, especially those with money in retirement plans and those in the western time zones.   The mandatory 2% (or higher) early redemption fee is another bad idea.  Fortunately, there are other proposals before Congress that would take a more balanced approach to solving the problems within mutual funds.

How About Some Sensible Remedies?

Fortunately, there are some sensible ideas out there.  Yet it remains to be seen if the mutual fund lobby will prevail with its self-serving ideas, or if the ideas discussed below will gain popularity. 

The most rational proposal I have seen to combat the practice of international arbitrage is to require mutual funds to use what is called “FAIR-VALUE” pricing.  This is a complex procedure, but in short it means that the mutual fund families would be required to use various factors such as late-breaking news, futures trends, etc. to determine a daily estimated fair-value price for each foreign stock held within an international mutual fund.  Doing this would provide investors with a “best-efforts” price for their mutual funds, but most importantly, it would eliminate the price ambiguity that these insiders trade upon.

Of course, the mutual fund industry and the ICI oppose mandating this form of pricing.  Why?  For one thing, the process of determining a fair-value price for a mutual fund is time consuming and expensive.  Never mind that it is better, fairer and eliminates the chances for abuses.  No, it’s a lot easier and less expensive to implement a 4:00 PM hard close.

On February 9th, more legislation was introduced in the Senate to safeguard the mutual fund industry.  In my opinion this legislation speaks to some of the core problems of the mutual fund industry without negatively affecting innocent investors.

The Mutual Fund Reform Act of 2004, introduced by a bipartisan group of Senators, seeks to correct the problems in the mutual fund industry by attacking the underlying governance and transparency issues inherent in the industry.  The big difference between this and other bills is that it is not a band-aid fix directed at the symptoms of the problems, but a bill that gets at the root causes.

One of the chief provisions of this bill is that it makes the board of directors of each mutual fund more responsible to its shareholders.  It does this by ensuring the board is truly independent of the fund family, requiring fund officials to adopt a code of ethics, and by empowering the board to exercise its fiduciary duties to protect shareholders.  It also requires fair-value pricing and strengthens enforcement of the short-term trading and early redemption fee rules that are already in place.

Aside from addressing issues related to the mutual fund scandals, the bill also seeks to improve the transparency of mutual fund fees and actually prohibits such standard mutual fund practices as paying 12b-1 fees and bonuses to brokers who promote a fund’s shares to investors.

In my opinion, the Mutual Fund Reform Act would effectively address the root causes of the mutual fund scandals by making some major changes in the way the fund industry does business.  Not surprisingly, the ICI and mutual fund industry generally oppose this legislation.  ICI president Matthew Fink says this proposed legislation “contains many ill-defined new legal standards that could change mutual funds’ essential structure,” that “would seriously jeopardize the interests of current and future mutual fund investors.”  (Source:  ICI President Issues Statement on Additional Legislation Proposed by Members of the Senate Governmental Affairs Comm. - CLICK HERE).

Excuse me, but wasn’t the current mutual fund “structure” (selective enforcement of rules and special deals for big investors) the cause of the current problems?  Sounds to me like the only interests being seriously jeopardized belong to those in the mutual fund industry who want to profit at the expense of the shareholders.  I believe the Mutual Fund Reform Act is right on target, and I encourage you to contact your Senators and show your support for Senate Bill S.2059.


I hope this discussion about the ongoing efforts to solve the problems in the mutual fund industry has been helpful.  I continue to believe that mutual funds are an important part of an investor’s portfolio, and I haven’t lost my faith in them.  I believe the mutual fund industry will emerge from these scandals stronger then ever, but with stronger shareholder protection and disclosure requirements.

Obviously, the industry is leaning toward some “quick fixes” that will penalize investors and reduce flexibility.  The last I heard it was not general practice to allow wrongdoers to have a great deal of input into the laws and regulations designed to prevent their illegal activities.  However, that’s exactly what is happening in the mutual fund scandals even as this is being written.  The ICI has testified before Congress and has strongly supported the SEC’s 4:00 PM hard close and 2% minimum early redemption fee proposals, and is lobbying hard on Capitol Hill. 

At the same time, there are plenty of Senators and Representatives in Washington who can’t wait to attach their names to new legislation being touted to protect investors.  Unfortunately, there are many in Congress who either do not understand the issues, or can be bought by the ICI, or both. 

Our leaders need to understand that the foxes are in the hen house!  We don’t need a 4:00 PM hard close.  We don’t need a mandatory early redemption fee.  The fund families need to police their own rules.  They should kick out those who would abuse the flexibilities of the system.

They just have to do what is right.  With $7 trillion of our money in mutual funds, is that too much to ask

All the best,

Gary D. Halbert



Proposed “Reforms” Would Hurt Individual Investors



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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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