Market-timers get new scrutiny as funds press fight against them

Last spring, AIM Funds Management Inc. was approached by a deep-pocketed hedge fund looking for a place to invest $1 billion and "move it around."

The Houston mutual fund company declined.

The hedge fund, which AIM executives would not name, wanted to time the market with AIM's permission -- or trade in and out of mutual funds to reap gains on daily fluctuations in the price of fund shares -- said Ira Cohen, a senior vice president at AIM, which oversees $115 billion.

Most fund groups forbid short-term trading in their funds, because it racks up transaction expenses for the ordinary shareholders who invest for the long term, and it can hurt their returns over time.

"We fight this battle every single day," Cohen said. "We get offered deals just about daily. There seems to be an incredible amount of money, especially in hedge funds, and they're just looking for a place to park it."

Market timing in funds used to be viewed as a nuisance, an arcane practice by a handful of cunning investors. But timing is now under the microscope of regulators in Massachusetts and New York, who say the practice is unfair to individual investors -- and in some cases illegal.

A few mutual fund groups permit timing, such as Rydex Funds. Most forbid the practice in their prospectus documents, however, and limit short-term trades to two per year. Many firms impose fees on short-term trades, as well.

These measures can be effective in deflecting timers to other firms, analysts said, but they are not foolproof. Rules that prohibit investors from short-term trading in funds work only if the fund companies have systems in place to monitor such moves, and the will to enforce the rules.

Eric Zitzewitz, an associate professor at the Stanford Graduate School of Business who published a paper on market timing last October, said in a telephone interview that some fund companies may look the other way when timers hop into their funds, perhaps to avoid ruffling the feathers of brokers who sell their funds.

Others might be willing to take the big chunks of money, even for brief periods, because their fees grow if the value of average daily assets in their funds increases.

The most lucrative short-term trading is in international funds, Zitzewitz said. In funds that focus on particular regions, such as Europe or Asia, he found that investors lost about 1.6 percent of their assets per year to market timers.

A typical scenario: A market timer buys an international fund on a day when US stocks rise or fall sharply, assuming the international fund will follow suit the next day.

Timers who buy international funds on days when the Standard & Poor's 500 index has risen and then sell on days when the index has fallen, Zitzewitz wrote, can boost their returns by 35 percent per year.

Some people argue that market timing is a fundamental right of investors, large and small.

"I am alarmed by mutual funds' increasingly discriminatory practices toward market timers," Representative Thomas Tancredo, a Colorado Republican, wrote in 2001 to then-Securities and Exchange Commission chairman Harvey Pitt. In Tancredo's view, investors should have the flexibility to "switch amongst funds at will."

Last year the fund industry, through its lobbying group, the Investment Company Institute, won permission from the SEC to use something called fair-value pricing to try to eliminate arbitrage opportunities with international funds and thus deter timers.

With fair-value pricing, a fund group recalculates the price of a foreign fund, using market data such as futures prices, to update the value of the stocks in the fund hours after the markets have closed. This method involves assumptions, rather than official closing prices. But firms don't use fair-value pricing every day, which still leaves a window of opportunity for market timers. And not all fund managers have adopted the pricing policy.

"I was surprised that there wasn't a wholesale move to fair-value pricing," Zitzewitz said.

Executives at several major fund groups said they work hard to keep out timers, because the hassles of doing business with them far outweigh any potential benefits. Timers drive up administrative costs and dump cash into the lap of a fund manager too late in the day to be invested. Taken to an extreme, excess cash in a fund will dilute its returns. In addition, fund executives say, if a manager does quickly put the money into stocks or bonds, he or she might have to sell securities the next day, to come up with cash when the timers redeem their shares quickly. That can hurt long-term fund investors by racking up short-term, taxable gains.

Fund giant Vanguard Group in June added a 2 percent redemption fee to nine international funds, to prevent investors from holding funds for less than two months. The goal is not to collect the fee, the firm said, but to make timing unprofitable.

Gus Sauter, a managing director at Valley Forge, Pa.-based Vanguard, said short-term trading tends to surface industrywide when international markets are volatile, such as around the war in Iraq. "We want to make sure we protect the interests of the existing investors in the funds," Sauter said. He called the new fee preemptive, aimed at "ensuring that fund returns are not eroded by the exploitive actions of a few shareholders."

The AIM Funds have a relatively liberal policy of permitting five "round trips," or 10 trades in and out of its funds, by a single account holder in a year. But AIM's operations people try to keep a close eye on active traders, Cohen said, sending a warning letter after the eighth trade. If the broker makes a 10th trade, he said, "We put a stop on that account." AIM then contacts the headquarters of that broker's firm, demanding that the broker be prevented from further breaking the rules.

Cohen said that AIM, through these efforts, has eliminated at least $2 billion in unwanted fund timing over the past three years. That's just the hidden activity. Almost every day, he said, the firm turns away timers who call up and ask directly if they can place short-term money in funds. Boston-based Fidelity Investments levies fees of 0.5 to 2.0 percent on funds that could be vulnerable to market timers, spokeswoman Anne Crowley said. Fidelity has been granted SEC permission in the past to charge an anti-timing fee as high as 4 percent, an SEC spokesman said. Any short-term trading fees collected would go directly to the funds. If timers continue to make short-term trades after a warning, Crowley said, "We may take action to suspend -- temporarily or permanently -- their ability to purchase our funds."

Russ Kinnel, chief of fund analysis at Morningstar Inc., a Chicago research group, said timing "is a bad thing," and that firms have an obligation to guard against it. If they don't, he said, "You're hurting the people who are the long-term investors."

Beth Healy can be reached at bhealy@globe.com.