By Robert D. Klausner
What are the issues?
Since news broke concerning allegations of improper “market timing” and “late trading activities,” scores of public employee retirement plans have withdrawn billions of dollars from mutual fund and collective fund investments out of concern for multiple breaches of fiduciary responsibility by asset managers. How did this happen and what steps should fiduciaries be taking to protect retirement plans from further injury?
What are “late trading” and “market timing” and how does that hurt investors?
Mutual funds operate on forward pricing rules which means that the funds are priced at the next net asset value (NAV) calculated after an order is received. This rule is found in Rule 22c-1 enacted in 1968 under the Investment Company Act of 1940.
The vast majority of U.S. base mutual funds calculate the NAV once per day at 4 PM Eastern Time. Orders received prior to this time are valued as of the day of the trade. Trades received after 4 PM should be priced at the next day net asset value.
Prior to 1968, most mutual funds used “backward pricing” which priced trades at the most recent prior NAV. This allowed shareholders who were able to avoid sales loads to dilute the value for long term investors. The forward pricing rule was created to protect the average investor.
The current allegations against Putnam and other mutual fund companies is that hedge funds were allowed to place trades after 4 PM, in some cases as late as 9 PM, at the 4 PM price. These late traders were permitted to make financial decisions to go into or out of a fund based on knowledge that regular investors wouldn’t have; that is, the known value at the end of the trading day. In return for this favored treatment, hedge funds agreed to buy other financial products.
This late trading reduced the long term rate of return for the mutual fund thereby directly reducing the value of the shares of the non-favored participants. This means that for every dollar made by the hedge funds on this after-hour trading, the rest of the investors lost a dollar. According to the Stanford study, this practice cost the average investor, both institutional and individual billions of dollars. The estimate was that this practice cost the average investor in international equity funds approximately 5 basis points and 0.6 basis points in U. S. equity funds.
Market timing involves the frequent buying and selling of fund shares in response to market “signals” which the trader believes gives him an edge. These signals may involve the interpretation of market fundamentals or indicators or any other factor that may drive an investor’s decision making. Market timing, unlike late trading, is not illegal. It can, however, be disruptive to the management of the portfolio because of the need to retain larger sums of cash for liquidity purposes than would otherwise be retained. Market timing can also increase the commissions which lowers returns. Again, this can cause the performance of the portfolio to suffer. Lastly, many funds prohibit market timing in their rules, but have been found not to have enforced those rules equally. That disparate treatment is illegal.
As a result, the SEC has been encouraging funds to restrict market timing through a combination of fair value pricing (updating stale prices to reflect recent market movements) and additional fees for monitoring and short-term trading. Fair market pricing removes dilution opportunities to all investors. Fees, it has been suggested, may not be receiving uniform application to all investors. If favored traders are receiving an exemption from fees the market timing impact remains unequally applied to the average investor.
What have the mutual funds done wrong legally?
Mutual funds have a fiduciary duty to investors. This means that all actions must be taken in the best interest of the members of the fund. Fiduciary duty means “undivided loyalty.”
Late trading is illegal. That alone is a breach of fiduciary responsibility. More importantly, it places the interest of a few investors above those of the rest of the fund. It is being done to sell other products of the investment company which means that the financial interest of the company are being placed ahead of those of the fund.
Market timing also dilutes return. The mutual fund has the ability to forbid market timing in its rules or to place a premium on its practice which makes up for the loss to the fund as a whole. Failing to abide by a fund rule prohibiting market timing is also illegal as securities fraud.
Retirement funds have a fiduciary duty to protect the interest of their members. Many states have adopted this requirement by legislation as well as incorporating the prudent investor standard from the Employee Retirement Income Security Act of 1974 (ERISA) (26 United States Code, Section 1104). While ERISA does not apply to plans maintained by state or local government entities, the ERISA standard of acting as a prudent investor has been widely adopted. Armed with the knowledge that a mutual fund, or any investment professional, has compromised the integrity of the retirement fund, the Board of Trustees has a duty to act and replace the manager.
What has the SEC done to fix the problem?
On December 3, 2003, the Securities and Exchange Commission (SEC) proposed three rules to address market timing and later trading. Public comment is still being received.
The first rule would require any order to purchase or deem fund shares be received by 4 P.M. The would arguably eliminate the potential for late trading through intermediaries that sell mutual fund shares.
The second rule would require funds to establish compliance policies and procedures and review them annually. Each fund would also have to designate a chief compliance officer who would report to the fund board of directors rather than to fund management. The SEC stated in its press release at the time of the introduction of the rules (Release 2003-168), that the rule would improve accountability and make investigations more efficient.
The third rule requires funds to adopt enhanced disclosure rules relating to market timing and fair valuation of securities. This rule is designed to provide additional information to investors to guide their decision-making through an increased understanding of the policies of a particular fund.
What can an institutional investor do to protect itself?
There are a number of steps in light of the recent revelations that institutional investors can do to protect themselves:
- Ask all investment managers for a statement of their compliance policies with SEC rules.
- Direct communication with managers, beginning with the selection process.
- Adding contractual penalties for SEC rule violations.
- Require immediate notice of any SEC or other investigation of company trading practices.
- Provide for return of fees in instances of fraud or breach of contract.
- Adopt investigatory policies as part of the investment policy required .
- Remain current on news issues.
- Trustee education through NCPERS programs.
- Taking an active role in securities litigation class actions.
What should defined contribution plan participants be doing?
- Fund selection must operate on the same fiduciary principles as in the defined benefit plan.
- Member education and communication.
- Enhanced reporting.
- Careful review of plan prospectus’ regarding market timing.