Companies step up detective efforts to curb market timing

Every day in the waterfront headquarters of Eaton Vance, computers spit out a rap sheet, of sorts, of potential market timers trying to game the Boston firm's mutual funds.

The lists are of suspect trades, from an investor who switched in and out of a fund lately, for example, or of a sudden large trade into international funds when foreign markets are volatile, or an out-of-the-blue order from a previously unknown broker at a brokerage branch.

Eaton Vance's 48 in-house sales representatives, or internal wholesalers, as well as members of a six-person operations team pore over these lists for trades that seem out of character for the investor or the outside broker making the trade. They'll do a more detailed computer analysis to see whether there is a pattern of frequent trading in and out of other funds.

Eaton Vance officials will also call the broker, or the brokerage firm's home office, and ask directly whether the investor behind the trade intends to be a long-term holder.

If the answer is no, or if the brokerage's explanation isn't entirely convincing, then Eaton Vance will most likely reject the order as a potential market-timing trade.

Mutual fund companies such as Eaton Vance say they engage in such detective work because market timing -- the rapid trading in and out of mutual funds -- eats into investment returns by raising fund expenses paid by long-term investors and forcing portfolio managers to keep more cash on hand. Normally a low-profile, back-office function, effective policing of market timers has now become a major issue for the mutual fund industry, after state, federal, and industry regulators revealed they are investigating several mutual fund companies for allegedly bending rules to accommodate big-dollar trades from market timers.

Still, as much as mutual fund companies say they don't like it, there is money to be made in market timing. New York Attorney General Eliot Spitzer said in his investigation that several mutual fund companies, including Janus Capital Group, allegedly allowed New Jersey hedge fund Canary Capital Partners to market-time their funds, in exchange for side deals that brought in extra revenue. Eric Zitzewitz, a professor at Stanford University Graduate School of Business, said some mutual funds he's studied have permitted market-timing activity that equals as much as 5 to 10 percent of the fund's assets. The market timer's money raises the fund's revenue base during the period it stays in the fund, increasing the management fees the company rakes in. "You get all this extra revenue, and no extra costs, so that can be a good deal," Zitzewitz said.

But, he added, the short-term profits from accommodating market timers are outweighed by lower long-term performance, dilution, and higher expenses that market timing foists on remaining shareholders.

So mutual fund companies use several tools to take the profit out of rapid trading, including hefty fees for investors who sell a fund after a short holding period. While effective, such barriers don't always keep out stealthy pros who try to sneak in a quick trade, which is why fund companies prowl trading data.

"It's a cat-and-mouse game," said Michael Caccese, an attorney in the Boston office of Kirkpatrick & Lockhart who represents mutual fund companies. "These market timers, part of their game is to outsmart the mutual funds, through dummy accounts, changing account names. The mutual fund will kick them out and they go from fund to fund."

One trick is "splitting the ticket." That's when a larger trade, say $250,000, is flagged by a mutual fund's computer, and officials reject the order as suspected market timing. So the trader breaks the order into three trades that are small enough to fly under the computer's radar. But since the timer is moving quickly to be ahead of developing market conditions, the rejected and follow-on orders may come just minutes apart.

At T. Rowe Price's operations division, employees are on the lookout for such patterns. "The human eye catches it, by evaluating trades of firms we would have some concerns about," said Scott Such, vice president of retail operations. T. Rowe officials then call the firm making the order to enquire further about the trades, essentially putting the trader on notice that the mutual fund is on to him.

Indeed, many mutual fund companies say they either know or have a pretty good idea who the market timers are, and keep tabs on them. T. Rowe Price from time to time may zero in on smaller trades to give greater scrutiny to suspected investors, traders, or securities firms.

Eaton Vance starts with a very basic threshold to flag potential market timers. Computers every day identify accounts that have made two round-trip trades -- moved money in and out of mutual funds -- within the last 12 months. Eaton will then look at the client's broader trading history over a 90-day period, to see whether a pattern of frequent trading, or exchanges out of other funds, is emerging. The scrutiny would fall on either the investor himself, or the registered broker, or rep, who actually places the trading order with Eaton Vance.

"If I see a rep with a lot of exchange activity in 90 days," said Russell Curtis, Eaton's director of mutual fund operations, "I'm going to suspect that falls outside of what we designed mutual funds for," which is long-term investing.

Eaton also uses other computer screens to flush out market timers, paying particular attention to unusual activity in its international funds, since the difference in closing times between overseas and US securities markets could present "time-zone arbitrage" opportunities for traders.

Moreover, Eaton Vance's funds are sold only through securities brokers and investment advisers that have established relationships with the firm. That means Eaton Vance knows clients' investing habits, so unusual orders or unknown traders will stick out.

"There are so many little markers that say `Look at me!' that by the time you're willing to make the call, you know you're right," said Jeffrey Beale, chief administrative officer.

Over the past 12 months Eaton Vance said it had shut more than 200 accounts it concluded were engaged in market timing. The firm said it has 1 million accounts.

Unlike Eaton Vance, T. Rowe sells mutual funds directly to retail investors. Here, it's pretty easy to head off market timing. Retail investors who've traded in and out of a fund two times within a 120-day period automatically receive a warning letter about T. Rowe's policy against excessive trading. "It's maybe someone who came in to a fund and changed his mind," Such said, adding that a letter is usually enough to stop the trading so the firm doesn't have to shut down the account.

Despite the scrutiny that market timing is receiving since the allegations of abusive trading practices, mutual fund companies said they don't see any drop-off in the number of attempted trades from market timers. "I find that unbelievable," said Eaton Vance's Beale. "It's brazen behavior."

Andrew Caffrey can be reached at caffrey@globe.com.