Economist Eric Zitzewitz on exposing, corralling market timers
The mutual fund industry has sold Americans for decades on the notions that long-term investing is the best way to build wealth and that funds are the best vehicle for doing so. The pitch was made easier by the fact that funds have led a largely scandal-free existence. But Attorney General Eliot Spitzer of New York changed that Sept. 3, grabbing headlines with what he called "widespread illegal trading schemes" that cost fund shareholders billions of dollars a year. In court papers, Spitzer cited the work of economist Eric Zitzewitz. The Stanford University economics professor spoke this week with Globe business reporter Scott Bernard Nelson.
Q. To hear regulators and journalists tell it, market timing and late trading are the biggest financial scandals since Enron. But what, exactly, are we talking about?
A. The issue here is that prices are supposed to be set in the market. But with open-ended mutual funds, prices are set by an accounting formula, used to calculate something called ``net asset value.''
What we've seen is the NAVs that are calculated turn out to not be good indicators of real market value, and the people who are running the funds haven't had a strong enough incentive to fix the problem.
Q. That's the background. But what is market timing and what is late trading?
A. Late trading is placing trades after 4 p.m. using information that came out after the prices were set - but still getting the pre-4 p.m. price. The attorney general called it betting on a horse race after the race is over. It's like betting on a horse race after the first quarter mile, really. But it's still an advantage, which is why it's illegal.
Market timing is taking advantage of the way funds calculate their prices, which I talked about. Funds have historically calculated their prices in a way that under-incorporates recent market movements. For an international fund, they will just take the closing prices that are 12-to-14 hours old and not update them.
So a market timer is waiting for a day when those prices are very different from current value and then jumping in to take advantage of it. It's not illegal. It's a problem when a fund denies that right to some people and allows it for others.
Q. How big of a problem is it?
A. The cost of market timing to buy-and-hold investors is about $5 billion a year across all asset classes. Late trading is adding another $400 million to that. But it's not uniform across all asset classes, of course. You see it most in international funds and small-cap funds.
Q. What comes next for the industry?
A. Oversight has been weak on this issue. I would expect that it's going to get a lot better. The best solution on the table for market timing is to update the prices for the recent market movements - make the prices better reflect reality. The industry's been much more into stopping the problem with fees and monitoring. But now we know that the fees and monitoring weren't being applied equally to everybody. With late trading, you just have to monitor for it. You can imagine a board of directors asking a fund to do the kind of calculations I have done in my research, and report it each quarter. If it blips up, the board can ask for an investigation.
