Feeling the heat

Market timing – or “hot money” – has caused a scandal in America but the British fund industry denies it is a problem here. However, like other US practices, could it become a significant issue on this side of the Atlantic? Will Jackson finds out.

After an industry is shaken by a scandal it is often worth reviewing with the benefit of hindsight. This is certainly true of the American fund scandal of 2003, when it emerged that speculative trades by institutions meant private investors were losing money.

At the time, the British fund industry argued that the problem was virtually non-existent over here. But it is worth re-examining whether such practices could still be a problem on either side of the Atlantic.

The market timing scandal that engulfed the American mutual fund industry had dramatic effects on the firms involved. Putnam Investments, for example, reportedly lost more than $4bn (2.1bn) in assets in just two days, following the withdrawal of several pension plans. Senior figures in the industry were charged with criminal offences and at least one high-profile firm changed its name to avoid future associations with the scandal.

Market timing is perhaps best described as the rapid trading of a mutual fund, to take advantage of discrepancies between the price of the underlying securities and the net asset value ascribed to the fund by the manager. The practice allows larger, more sophisticated investors to make virtually risk-free profits, at the expense of long-term fundholders – often private individuals.

Timing affects a fund in several ways. First, the large, short-term movements of money associated with timing – sometimes dubbed “hot money” – cause dilution of the NAV for all investors in the fund. In the example shown (see below), investors selling the day after the timer’s inflow will receive less per unit than would otherwise have been achieved. The timer is free to redeem his units at a healthy profit.

Meanwhile, managers concerned by regular, and often large, inflows and outflows of cash are forced to ignore the long-term strategy of the fund, in favour of holding more liquid assets. For instance, a manager may be reluctant to increase his equity positions if he expects a recent large inflow to leave the fund within a few days.

In addition, increased buying and selling causes the fund to incur the costs associated with market spreads and broker commissions. This raises running costs, which are ultimately passed on to long-term investors. Because the timer may only be invested for a few days, it is unlikely he will pay his fair share through management fees.

But is it a problem that still needs to be addressed within the British mutual fund industry? In the wake of the revelations in America, a 2004 Financial Services Authority statement revealed that it had identified only a limited amount of British market timing. Overall, just 118 of the 9,620 transactions examined by the authority required further investigation, and the total amount payable in investor restitution was estimated at less than 5m.

The FSA said that its principles and rules gave sufficient power to managers to deter and deal with improper trading. “We can find no sign either that market timing is widespread, or that it has been a major source of detriment to long-term investors,” said the statement.

Robin Gordon-Walker, a spokesman for the FSA, says the estimated restitution was about right. “We did identify a figure of around 5m and asked firms to refund that by upping the units,” he says. “But overall it was very marginal. It was certainly not on the same scale as the US, where late trading came into it as well. When you have collusion between fund managers and customers, you are on a different scale of things. It is corruption and extremely serious, but not what we are talking about here.”

The American scandal began to unfold in September 2003, following an investigation by Eliot Spitzer, New York’s attorney general. Spitzer focused on two practices: late trading and market timing.

The former is simple to define but hard to detect. The current pricing system for American mutual funds was introduced by the Securities and Exchange Commission, the industry regulator, in 1968. Mutual funds are valued daily at 4pm New York time, the closing point of the New York Stock Exchange. Orders placed after 4pm are priced the following day. But this seemingly clear-cut system is complicated by the role of American intermediaries, including brokerages, insurers and retirement plans.

Provided their clients are able to submit trades before the 4pm deadline, intermediaries are permitted to place deals, on their behalf, well after the cut-off. Some unscrupulous firms use this opportunity to disguise the deals of late-trading clients. This allows individuals to deal at a set price, with the knowledge of events that have occurred after the market close.

Spitzer identified several firms and individuals engaged in late trading. In February 2004, Paul Flynn, former managing director of equity investments at Canadian Imperial Holdings, a subsidiary of Canadian Imperial Bank of Commerce, was accused of submitting late trades, up until midnight. The trades, on behalf of two hedge funds, were made through an intermediary firm, which disguised them using retirement and pension plan money.

Flynn was arrested and charged with five felonies, including two counts of grand larceny in the first degree. CIBC later resolved Spitzer’s investigation into its business with a settlement of $125m in July, 2005. Of this, $100m was paid in restitution to investors, with a further $25m in civil penalties.

Following the initial revelations, and the discovery that 80% of firms allowed late intermediary trading, the SEC moved quickly and voted in favour of a “hard” 4pm cut-off, in December 2003. “This rule would effectively eliminate the potential for late trading through intermediaries that sell fund shares,” said a statement. However, industry consensus was not achieved and the proposal is still awaiting approval.

Market timing is perhaps harder to both define and detect than late trading, although the effects can be similar. Timers often use time zone differences to exploit stale pricing. Take, for example, an onshore fund trading in listed British securities. The fund has a trading cut-off of 5pm and is valued soon after, at 6pm. The time difference between market closure and valuation is small and any potential pricing discrepancy is minimal. However, a fund trading in Korean securities with the same cut-off and valuation points, and not subject to the Investment Management Association’s recommended controls highlighted later in this article, is susceptible to timing. Because of the time zone difference, the security prices used to determine the 6pm NAV have been stale for several hours.

In addition, assuming East Asian markets tend to follow volatile movements in American indices, a British market-timer is able to monitor the first few hours of American trading before deciding whether to buy or sell at 5pm. A quick-thinking timer holding a Korean mutual fund on September 11, 2001, the day of the World Trade Center attacks, would have been able to sell out of the position at the price set in Korea earlier the same day. By doing so, he would have avoided the sharp fall in the Korean market when it reopened on September 12.

The problem of stale pricing, with regard to East Asian markets, can also be exacerbated by market holidays. While the markets are closed for trading, the British mutual funds that invest in them are often open for business.

Spitzer found that so-called “sticky” assets were often given to firms by market timers wishing to use their funds. These are typically long-term investments, in another vehicle run by the fund manager, that assure a steady flow of management fees. An example of this was found in the trading permitted by James Connelly Jr, former vice chairman and chief mutual fund officer of Fred Alger & Company.

Connelly was arrested in October 2003 and pleaded guilty to tampering with physical evidence related to the investigation of improper trading practices. According to the complaint, Connelly took several measures to thwart the investigation, including deceiving his own firm’s lawyers and ordering subordinates to delete sensitive emails. The SEC found that Connelly had approved agreements permitting certain investors, including a Texas-based hedge fund, to time several funds run by the firm. In return, timers were required to keep 20% of their assets sticky.

While market timing itself is not illegal, unlike late trading, it is almost always contrary to the rules set out in fund firms’ prospectuses. In Britain, the practice can also be seen as going against both principles six and eight of the FSA. These are: that firms must “pay due regard to the interests oftheir customers and treat them fairly”, and “manage conflicts of interest between a customer and another client”.

Gordon-Walker says trustees have played a central role in the avoidance of an American-style scandal. “The trustee has an important role in the UK,” he says. “Any funny business between a market timer and a fund manager is unlikely. Trustees are more aware of the danger than they were and our analysis is there is not a similar role in the US.”

Richard Eats, communication consultant at Cofunds, agrees the presence of trustees, in conjunction with good corporate culture and industry respect for the FSA, has reduced the likelihood of a British scandal. “Fund managers buy units from, and sell units to, the independent trustee or depositary, usually a major bank” says Eats. “They are on the other side of the activity and are regulated firms, with a general duty of care to investors. It is a role they take very seriously and they would investigate if there was suspicious trading. There is a lot of talk about independent directors from time to time, but trustees offer strong protection for investors because they are involved in the business day to day.”

While the FSA’s 2004 statement was generally upbeat on the limited scale of British market timing, it also acknowledged concern from fund managers on the rise of “order aggregators”. Aggregators, including fund supermarkets, sometimes trade on behalf of thousands of clients, placing one or two bulked daily trades. This makes it almost impossible for fund companies to track the trading patterns of underlying clients.

Despite this, the FSA statement was emphatic that fund managers are responsible for the trading in their funds. “While recognising these difficulties, we remind firms of their obligations,” it said. “If fund managers are unable to satisfy themselves thatpotentially suspicious deals are not on behalf of market timers, we suggest they use the range of tools at their disposal and do not allow any unduly preferential dealing arrangements.”

Eats agrees the responsibility should lie with fund managers but says Cofunds has basic monitoring procedures in place. Monthly dealing reports, showing trades above a certain size, are sent to fund companies for analysis. Any suspected timing can then be discussed with the relevant group, although this has not yet been necessary in practice. “Cofunds is a regulated entity,” says Eats. “It is more likely timers would choose to go through an offshore nominee. But we do keep a weather eye out for dealings.”

Fidelity Investments, owner of the FundsNetwork platform, declined to comment on its monitoring procedures.

Philip Warland, senior adviser at PricewaterhouseCoopers and director general of the IMA until 2001, says the use of platforms by timers is unlikely. “Platforms would have too much to risk by allowing timing,” says Warland. “Even if trades are aggregated, they will only submit bulked deals in line with timing parameters.”

Seven months after the FSA statement, the IMA produced a 20-page document entitled “Market timing: guide- lines for managers of investment funds”. While the guidelines are meant as helpful suggestions, rather than an enforceable framework, the IMA is also clear on where the responsibility for deterring timing lies. “Even if the manager has not afforded any special treatment to the market timer, he still has a fiduciary obligation to take all reasonable steps to discourage such traders,” it says.

The guidelines first suggest the adoption of an “appropriate supervisory structure” by fund firms. This includes: the appointment of a senior manager to oversee controls, formal acknowledgment of the responsibility of relevant staff to escalate suspected abuses, and staff awareness and procedural training. In addition, there should be policies in relation to short-term staff trading and ensuring that managers’ strategies do not include the timing of other investment funds.

The document also recommends that managers have monitoring systems in place, appropriate to the firm’s assessment of the risk and likely effect of timing on its funds. The parameters should remain confidential to avoid investors operating just outside the limits. Managers should also consider the use of “high-level analytical tools”, including monitoring the level of deals in and out of a fund, as a percentage of total net assets. The monitoring of total sales to redemptions ratios is also suggested, with a consistent one-to-one ratio indicating that a fund is being timed.

The guidelines recommend several further measures to reduce the attractiveness of funds to timers. To tackle the issue of stale pricing, the IMA suggests the review of dealing cut-off and valuation points. The use of “fair value” pricing should also be considered, it says.

Where a market is closed at the valuation point, managers are able to make pricing adjustments to reflect the value of the portfolio more accurately. If used correctly, the system can reduce the effects of stale pricing – in East Asian and American funds in particular.

A separate guide on fair value pricing was produced in conjunction with the Depositary and Trustee Association, to further aid firms. Finally, dilution levies and redemption fees, charged for clients with excessive trading, may also be imposed.

If these measures fail, several options are open to managers. Firms may refuse to deal with an identified timer or require settlement in advance of an order, by withdrawing any non-standard dealing privileges. The measure is designed to remove a timer’s ability to place buy trades at short notice. Firms may also impose “in specie” redemptions, where a timer receives the fund’s underlying stocks in the relevant proportions. However, this is an operational burden on the manager and should only be used as a last resort.

While it appears no record has been kept of how many firms have adopted the IMA’s proposals, the FSA’s Gordon-Walker is confident that market timing is under control. “Fund providers are protecting long-term investors and we believe our principles and rules are sufficiently tight,” he says. “But while there may not have been much evidence of systematic market timing, the industry cannot be complacent. It is like security: you cannot drop your guard and you never win. Our message is constant vigilance.”

PwC’s Warland agrees that firms must remain alert. “It is always safest to assume your fund is being timed, particularly if the markets are closed at the pricing point,” he says. “You cannot always spot timing activity and some guys are clever enough to spread the same order around 20 brokers.”

But for the time being, the FSA’s focus appears to have shifted to addressing timing in the unitised business of the life insurance industry. “You have investors making lump sum or regular payments into equities and it is very similar to collective investment schemes,” says Gordon-Walker.

“In a sense, they are operating a unit trust under the umbrella of a life insurer but with different governance. The FSA is developing ways of improving the governance and operation of the unitised business, in conjunction with the industry, to put it on the same level as CISs. Work started in the second half of last year and we’ll be making an announcement soon, so watch this space.”

Will Jackson used to work in the compliance department of a large fund management group, where his responsibilities included monitoring for possible market timing.

How the scandal broke in America

September 2003: Eliot Spitzer announces that his office has obtained evidence of widespread illegal trading schemes – a $40m (21m) settlement is agreed with hedge fund Canary Capital Partners, two Canary-related entities and Edward Stern, managing principal of the entities. Canary is accused of obtaining special trading agreements with Bank of America’s Nations Funds, Banc One, Janus Capital Management and Strong Capital Management. BoA broker Theodore Sihpol III is charged with larceny and securities fraud.

October 2003: Steven Markovitz, former executive and senior trader with hedge fund Millenium Partners, is charged with late trading. James Connelly, former vice chairman and chief mutual fund officer of Fred Alger & Company, pleads guilty to tampering with physical evidence related to a timing investigation.

November 2003: Putnam Investments reaches agreement on restitution and structural reforms with the Securities and Exchange Commission. Market timing by Putnam employees is alleged. Spitzer announces his office will continue to investigate. Civil charges are brought against Gary Pilgrim and Harold Baxter, founders of PBHG Funds. Spitzer alleges the two men allowed timing of their fund range by favoured clients, including a hedge fund and a broker dealer. Felony charges are brought against three senior executives of Security Trust Company, accused of assisting late trading by hedge funds.

December 2003: Spitzer announces civil charges against Invesco and its chief executive officer, Raymond Cunningham. Documents are produced showing senior executives were aware of a market timing scheme for favoured investors. The complaint claims typical investors have lost millions of dollars. Settlement of $600m is reached with Alliance Capital Management, regarding the allowance of timing. $250m is paid in restitution to investors and fees are to be reduced by $350m over the next five years.

February 2004: Paul Flynn, former managing director of equity investments at Canadian Imperial Holdings, a subsidiary of Canadian Imperial Bank of Commerce, is arrested. Flynn is accused of conducting late trading and market timing for two hedge funds. Boston-based Massachusetts Financial Services resolves charges that it permitted market timing, with a $350m settlement. Fees are to be reduced by $125m over five years and $225m is to be paid in restitution and penalties. Civil charges are filed against two subsidiaries of FleetBoston Financial, for allowing timing in its funds.

March 2004: BoA and FleetBoston settle jointly for $675m, before their impending merger. BoA is accused of allowing timing in its Nations funds by favoured clients, while imposing a 2% redemption fee for typical investors holding units less than 90 days.

April 2004: BoA broker Theodore Sihpol III is indicted on 40 counts at New York’s County Supreme Court. Janus settles for $225m. Payments of $50m in restitution, $50m in penalties and $125m in reduced fund fees are made.

May 2004: Strong settles for $175m. The firm’s founder, Richard Strong, receives a lifetime ban from the securities industry.

June 2004: PBHG settles for $100m, with $50m in penalties, $40m in restitution and $10m in reduced fees. Banc One settles for $90m.

August 2004: Subsidiaries of Conseco and Inviva, insurance companies, agree to pay $20m to resolve allegations of timing in mutual funds linked to variable annuity products.

September 2004: Invesco and AIM, affiliated companies, settle for $450m. Total damages of $235m and penalties of $140m are paid. Fees are to be reduced by $75m over five years.

October 2004: Robertson Stevens settles for $30m, to resolve allegations of allowing timing in its funds.

November 2004: San-Francisco based Fremont Investment Advisors settles for $4m, regarding an investigation into market timing and late trading. PBHG founders personally settle for $120m in restitution and $40m in penalties. Both men receive a lifetime ban from the securities industry.

January 2005: Two brokers at Florida-based Kaplan & Company Securities plead guilty to criminal charges of engaging in late trading. Both men agree to a fine of $750,000, split equally.

June 2005: Spitzer’s first high-profile defeat occurs. Theodore Sihpol III is acquitted on 29 of the 40 counts brought against him.

July 2005: CIBC settles for $125m and agrees to a series of reforms.

August 2005: Grant Seeger, former chief executive officer of Security Trust Company, and William Kenyon, president, plead guilty to criminal charges.

September 2005: Spitzer commences legal proceedings against Seligman, related to market timing in its funds.

October 2005: The criminal case against Theodore Sihpol III is completely dismissed.

November 2005: Federated Investors settles for $100m in restitution, penalties and fee reductions.

December 2005: Millenium Partners, its founder Israel Englander and two management firms owned by Englander settle for $180m. Millenium is accused of conducting 76,000 timing transactions, through more than 100 shell companies. Texas hedge funds Veras and VEY Partners, accused of late trading and market timing, settle for $40m. Spitzer announces that total settlements have reached more than $3.3bn.

January 2006: Daniel Calugar, former head trader and owner of Securities Brokerage, pleads guilty to market timing-related charges.

Example of dilutive impact on a fund and profit to an arbitrageur
A fund with 10 million units in issue is to be priced at 10 at the next valuation point, using stale market close prices. The fund is 100% invested in securities.

Based on the news flow since the underlying market closed, a market timer believes the fair value of the units is 10.50. The market timer places a buy trade of 500,000 units, costing 5m. The following day, the underlying market rises 5.3%. The fund manager does not invest any more cash into securities. The fund now has 5% liquidity, following the receipt of market timer’s monies.The fund value is now 110.3m: 105.3m securities (100m x 1.053%); and 5m cash.

Based on 10.5 million units in issue, the unit price is now 10.505. If the market timer had not traded with the fund, the valuation would have been 105.3m: 105.3m securities; nothing in cash. Based on 10 million units, the unit price would have been 10.53.

The market timer has seen a virtually risk-free profit on the day of 5.05%. The potential return for continuing investors is 0.24% lower than it would have been without the market timer’s trade.

Adapted from the Investment Management Association’s “Pricing Guidance for Investment Funds: Fair Value Pricing”.