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Fund trading update
Little new information revealed

The financial media this past week was filled with the latest details of the Ontario Securities Commission's investigation into suspicious trading of mutual funds. AGF, AIC, CI, and IGM Financial (formerly Investors Group) each issued press releases this past week confirming that they are the four firms referred to in the OSC's press release confirming the forward movement of its on-site investigation.

No new information

The media made a big deal - by printing multiple stories for two days running - about these latest developments. Striking is that all of this ink was devoted to an issue with a grand total of new information equal to the first paragraph of this article.

Prior to the latest press releases, we knew that institutional market timers had been present in Canadian-sold foreign funds. I said as much in an article last September. I also opined that I did not expect any meaningful amount of the illegal practice of late trading, if any at all. In fact the OSC confirmed that no late trading is suspected.

So, what do we know now that we didn't previously?

Well, for one, the OSC confirmed that it is moving forward - despite the heavy criticism lobbied at Canada's largest securities regulator when it first sent out its questionnaire. We also know which companies are the focus of the first set of in-depth on-site reviews. Other than that, we have no new information.

Market timing and market timing

Despite the many articles on this topic over the past week, I have not seen a differentiation between the two forms of market timing present in the fund industry.

The first, more obvious type is the scandalous but legal exploitation of time zone differences and stale prices of funds investing overseas. Let's call this "time zone arbitrage". If allowed, this practice effectively skims money from other unitholders, increases fund operating expenses, and provides higher management fees (in dollars) to fund companies thanks to the big bucks ponied up by such traders.

Another form of market timing has been present for years and is growing. It is motivated quite simply by making money from attempts to forecast future market movements by reading price and volume charts. In other words, I'm talking about the growing number of people trading based on technical analysis - including both advisors and, to a lesser extent, individuals.

Without detailed transaction data that only fund companies possess, it is impossible to decipher one form of market timing from the other.

Short-term trading fees

I'm no legal pro, but it seems to me that key to determining whether time zone arbitrage should result in penalties for the fund sponsor is whether or not these big institutional traders received special treatment. The obvious thing to look at is whether short-term trading fees were applied only to some parties but not to others - or in a way that does not seem to conform to any firm policies.

The difficulty in making this case is that most load fund companies, unofficially, had a policy of allowing short-term trades. Prospectuses were always worded in such a way that the fund company reserved the right to charge up to 2 percent of the value being sold or switched. (Now, of course, an increasing number of them are making such fees mandatory.) Short-term switching would be allowed, generally, until such trading began to occur too frequently and involved too much money. Load firms that levy short term trading fees have historically been the exception, not the norm. Hence, this might be a tougher case to make if any time zone arbitrage is revealed (which I believe it will).

Meanwhile, bank and no load companies generally exercised this option without exception.

Advisor reaction

If the attitude of advisors posting to Advisor.ca's online discussion forum is any indication, most advisors seem to want to downplay this issue to clients. They'd have a point that the media is blowing this a bit out of proportion based on the limited available information. But assuring clients that "it's nothing", or something to that effect, is an irresponsible and risky move that could come back to haunt them.

If anything, advisors should be leaning the other way since any company found of allowing time zone arbitrage not only betrayed unitholders' trust, but also that of advisors. Taking a more cautious, investor-friendly stance makes more sense when so much uncertainty remains. After all, the advisory and mutual fund industries were built and depend on the clients' life savings.

Restitution

If any fund companies are found to have allowed traders to engage in time zone arbitrage, other investors will have actually lost money. While not illegal, it seems to me that such activities could be considered a breach of the duty of care owed to unitholders by fund companies. Hence, in such cases, I firmly believe that affected unitholders should be compensated. However, the market timing done by pure technical traders is not something that should be punishable in my opinion - though new policies will dissuade frequent traders.

This investigation is just starting, and it will take time to work through the details required to confirm any wrongdoing, identify affected investors, and quantify losses. Until then, speculating on the outcomes is just that.



Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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