How Automation Can Deter Market Timing in Funds
October 20, 2003
For years, mutual fund managers have coped with sudden inflows of cash followed by abrupt redemptions, the result of market timers attempting to take advantage of short-term variances between a fund's daily NAV price and the prices of the underlying securities. While some fund companies are intentionally designed to facilitate market timing, most mutual fund firms seek to meet the needs of long-term investors. Volatile flows caused by short-term trading can diminish annual fund returns by more than a percentage point.
Many fund companies have tried to discourage market timing with redemption fees and other measures. Identifying and tracking short-term traders, however, can be a cumbersome, time-consuming process. Recognizing the challenges created by market timers, PFPC is now offering fund companies the ability to accurately identify short-term traders and impose fees and other penalties, including restrictions on trading by certain individuals or firms.
Day-trading in stocks may be a high-risk venture because of the potential for fluctuations in share prices hour to hour. International funds are a common target of market timers, because traders can gauge the direction of markets in Japan and Europe based on activity in the U.S. stock market after those foreign markets have closed. In domestic funds, market timing occurs most frequently in small-cap stock and high-yield bond funds, which are less liquid and in which the last transactions occur well before the market closes. In both cases, traders take advantage of stale prices on securities in the fund-in effect buying a stock or bond at a lower price or selling at a higher price than its current market value.
This type of trading activity can be profitable for the market timer. A recent academic study estimated short-term traders can generate annual returns of 30%, compared to 13.3% for buy-and-hold investors. Long-term investors are hurt because fund managers must maintain larger cash positions to accommodate quick inflows and outflows. A 2002 study estimated that fund investors are losing up to $4 billion a year to market timers, up from $1 billion in 1999.
Technology enhancements recently made by PFPC enable its fund servicing clients to track how long shares are held in an account and assess appropriate fees on shareholders who redeem or exchange shares within a set period of time. The flexible system also allows mutual fund companies to systematically monitor trading by broker/dealer or individual representatives or shareholders and place restrictions on those who repeatedly ignore short-term trading rules.
The hallmark of PFPC's automated services is customization that allows fund companies to adjust the holding periods and penalties for each fund, share class or account type, per each fund prospectus. These solutions are enabled by PFPC's Global Enterprise PlatformSM, which is designed to embrace open architecture that promotes flexibility, efficiency and easy integration.
Technology tools for monitoring market timers fall under two broad categories, short-term trader fees and dealer trade restrictions.
Using PFPC's automated system, a mutual fund company may require a specified holding period for shares in a fund with the certainty that every share purchase in that fund will be tracked and a fee assessed if the shares are sold before the end of the holding period. A company can assess a flat fee or charge a percentage of the proceeds on a short-term transaction - based on either the gross amount redeemed or exchanged, or the net transaction after contingent deferred sales charges, withholding and other fees. Most fund groups manually track short-term traders, a difficult process that is less effective, less accurate and allows for little customization.
Global Enterprise Platform coordinates short-term trader fees with all other fees and commissions, tracking and reporting year-to-date fees and other related information on online screens for shareholders, advisors and the fund company, as well as in all confirmations and statements.
Fund companies have the option of imposing restrictions on trading or share ownership, but here, too, the process is cumbersome. With PFPC's new technology, a fund company that suspects a dealer with 100 accounts in a fund is engaged in short-term trading now only has to enter a single command to monitor activity for that dealer.
As with the fee structure, a fund company can customize controls, applying them to all of a dealer's positions, or only on accounts held within particular funds. To enforce the rules set out in the prospectus, a fund company may implement: controls on exchanges; controls on exchanges and purchases; controls on exchanges, purchases and any sort of redemption. The automated system sets stop codes at all levels, from dealer to rep, to limit the activity of selected firms and protect long-term shareholders.
James W. Nolan is senior vice president and managing director of product development at PFPC and Barbara D. Buchner is senior vice president and managing director of transfer agency systems at PFPC.
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