Recent Fund Problems Need Correcting

This industry now faces several complex issues including New York Attorney General Eliot Spitzer's complaint against Canary Capital Partners (a hedge fund) regarding market timing and late-trading.

To better understand what's going on, let's break the subject down into four parts.

-First, hedge funds, which are private investment partnerships. Similar to mutual funds, managers of these funds also run pools of securities but typically use investment strategies considered aggressive and too risky for the average investor.

Unlike mutual funds, hedge funds are not registered with the Securities and Exchange Commission (SEC); are not regulated; the individuals selling them don't have to be licensed; and their shareholders must be "accredited investors" meaning that he or she has a net worth of at least $1 million.

So, when Canary Capital decides to invest its assets into say a mutual fund, it comes to that fund's door with big pockets full of money. Money that will up the fund's assets, will up the money the fund receives in management fees, and leave the fund's portfolio manager with the challenge of having a heap of new money to invest.

- Second, market timing. Talk with some fund family professionals and they'll say that market timing is anything short of keeping your money invested in the same fund for most of your life. To illustrate that point they usually referral to a chart showing how much money you'd have if you'd kept your money invested in the fund through both bull and bear market times versus pulling money out when the market had fallen and then getting back in when it was back on it way up.

Research shows that most investors are poor market timers who tend to buy when prices are high and sell when they are low, moving out of one fund and into another at precisely the wrong time. None of which makes making money very easy.

To prevent investors from market timing--or switching their money in and out of funds---fund families have imposed fees for trading in and out of funds not held for a specific amount of time. Fees that, by the way, impact everyone be they a large investor or a small one.

Market timing strategies are not illegal, even though they may put pressure on a fund's manager and dilute the fund's net asset value.

-Third, arbitrage. Arbitrage is literally profiting from the differences in price when a security is traded on two or more markets.

A time-zone arbitrage would mean taking advantage of the differences in the prices of a security trading on various markets around the globe.

-And finally, late trading. Decide to buy shares of a mutual fund today--before the market closes at 4 p.m.---and the per share price you'll receive will be based upon calculations provided after the close of business on the day the order was placed. So, if you place your fund order during business hours on Wednesday, your broker will likely call on Thursday to tell you the fund's per share price.

Late trading becomes illegal is if you were to get yesterday's price on a fund. Using the same example, that would be akin to placing an order for fund shares on Wednesday and getting Tuesday's per share price.

In Canary's case, the allegations of late trading involved a couple of things; international funds where time-zone differences provided an opportunity to take advantage of breaking news that would impact the price of securities, as well as receiving stale fund prices.

Jim Atkinson, CEO of Guinness Atkinson, used a Spitzer analogy when describing this kind of trading behavior: "It's like people placing bets when the horses are still circling the track."

A handful of mutual fund families allegedly allowed Canary late-trading opportunities. For those illegal actions, and to preserve the trust of millions of mutual fund shareholders along with the integrity of the fund business, the fund families involved need to be punished by more than a slap on the wrist.

"The damage that's been done by this is terrible for a lot of people. Not just people in the funds, " says Atkinson. "This is much more than a black-eye for the fund industry.

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Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.