Despite mutual fund companies' insistence that the scandal over illegal market-timing that erupted five years ago is an old and dead issue, there's never been a full industry-wide accounting of all investor losses.
The scandal resurfaced recently with Toronto-based law firm Rochon Genova LLP seeking class-action status for a lawsuit against the fund companies that agreed in December 2004 and March 2005 to pay a total of $205.6 million to investors. The fund companies say they've made restitution. The plaintiffs' lawyers disagree, contending that more should be paid to investors.
One of the lawsuit's key allegations is that hedge funds were allowed to trade frequently without being charged the short-term trading fees that are normally levied. This is true. What's debatable, however, is the lawsuit's allegation that short-term trading fees were charged at the time to all other investors.
During the 1998-2003 period in question, the short-term trading-fee provisions in fund prospectuses always made it clear that fund companies had the option to charge such fees. Regulators would then require that this discretion be exercised fairly.
My experience as an advisor and analyst at the time was that most fund companies did not charge short-term trading fees to any investor, big or small. The exceptions to this general practice were mostly no-load fund companies, including those sponsored by banks, which generally charge the maximum short-term trading fees to all applicable trades.
The other notable exceptions involved market-timing financial advisors who were trading in bulk on behalf of groups of retail clients. Most of these advisors seemingly did not take advantage of stale-dated prices in foreign stock funds, which is the type of market-timing that got the fund companies in trouble with the regulators.
Instead, the advisors made their trades for clients on the basis of technical-analysis factors. Only when some of these advisors began trading larger dollar amounts did fund companies threaten to start charging investors the maximum short-term trading fee on every applicable trade.
At the heart of the latest litigation against the five fund companies is how much damage was done to investors. The U.S. economics professor Eric Zitzewitz estimates that losses to Canadian investors resulting from market-timing range from about $300 million to $800 million.
Zitzewitz's estimate is based on a formula that he devised using aggregate fund flows. The lower end of that range is almost exactly what the Ontario Securities Commission calculated and used as the basis for the settlements.
But the OSC's calculation of profits from market-timing trades did not isolate hedge funds that exploited stale prices of foreign funds. As was evidently the case with Zitzewitz's reckoning, the OSC factored in all trades that they identified from all "frequent traders." These traders included the contingent of market-timing advisors who did nothing illegal.
The OSC's decision to obtain settlements with a select group of five fund firms reflects its goal of protecting markets rather than punishing all wrongdoers. Still, it's puzzling that the OSC did not seek to take any punitive measures against fund companies mentioned in the brokerage-firm settlements.
For instance, TD Waterhouse Canada Inc. was penalized for facilitating rapid trading in TD Canadian Small Cap Equity , as well as two Sovereign pooled funds managed by Russell Investments. Similarly, the RBC Dominion Securities Inc. settlement also confirms that some of the market-timing trades it facilitated occurred in its affiliated RBC fund family. But the fund company affiliates of the two bank-owned brokerages were left alone.
Also seemingly ignored by regulators was the adverse impact of frequent trading on money market funds. Consider this hypothetical example of a market-timer who invests $9 million in three foreign equity funds offered by the same fund company. When the market-timer decides to sell, all $9 million (plus profits) across the three funds are switched into the same firm's money market fund.
When the timer buys again, all $9 million moves out of the same money market fund and into the three foreign equity funds. While each of the stock funds had $3 million zipping in and out, the money market fund had three times the dollar-trading activity because it was involved in all of the market-timing transactions.
Frequent high-volume trading is harmful to holders of money market funds because the costs of trading will eat into interest yields. Commissions for trading money market instruments are built into the price quoted for buying or selling them. The spread between the two prices is the bid-ask spread, or the effective trading cost. Since market-timers at the time were typically flipping back and forth between stock funds and money market funds, these costs would add up.
The losses sustained by holders in money market funds probably pale in comparison to those suffered by investors in foreign equity funds. But I would bet that the losses to money market unitholders are still significant and, regrettably, have never been addressed.