Little Guys Were Market-Timing Funds, Too
By SHEFALI ANAND
August 25, 2006; Page C1
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There's a new wrinkle in the "market timing" scandal that has shaken up the mutual-fund business the past few years.
Three years ago, regulators charged several fund companies with breaking the law by letting large, favored customers rapidly buy and sell fund shares as part of a sophisticated strategy to profit from tiny price movements. The problem: Such rapid trading can hurt the typical little-guy investor, who usually buys and holds fund shares for long periods of time.
However, recent data show that in at least one fund company, it was the smaller investors -- not the large, favored clients -- who did the vast majority of this rapid-fire trading, known as market-timing.
According to an independent analysis of trading activity at Columbia Funds between 1998 and October 2003, market-timing activity cost the Columbia family of funds an estimated $150 million in potential gains. Of that amount, more than two-thirds was caused by investors who didn't have special arrangements with the fund company, a group which included individual investors and those trading through their basic 401(k) employee-retirement accounts. Only about $30 million of the total was attributable to nine big investors who had cut specific deals with Columbia to engage in rapid trading in some funds, in violation of the funds' prospectuses.
This kind of trading doesn't run afoul of securities regulations in and of itself; rather, it is a violation to cut deals favoring specific clients. Last year, the Securities and Exchange Commission charged Columbia Management Advisors Inc., the asset-management arm of Bank of America Corp., with fraud for entering into such agreements with at least nine companies and individuals. Columbia paid $140 million to settle the charges.
The results of the independent analysis, which was also required as part of the settlement, suggest that far more fund investors than previously thought were taking advantage of the fund's lax enforcement of its own rules against market-timing. In addition, the numbers suggest that a larger-than-expected pool of individual investors may have been playing out sophisticated strategies like these in recent years.
"This was widely practiced by [individual] investors," says Mercer Bullard, a law professor at University of Mississippi, and an advocate for fund shareholders.
While regulators have known before that some savvy individual investors were active market-timers, this is a rare case in which the losses caused by their trading at specific funds have been calculated in dollar terms.
A spokesman for Columbia declined to comment on the findings.
An independent trustee for some of the Columbia funds, Thomas Theobald, says the analysis shows there were a large number of people who perceived an opportunity to make quick profit, and did so. "What you see is the marketplace at work," Mr. Theobald says. He also believes that the fund company has now tightened its practices and therefore, "in my opinion, it's inconceivable that this sort of thing can happen again."
Since short-term trading can harm long-term shareholders, fund companies take several steps to rein it in, such as levying fees on purchases or sales made within a short span of time, say five days.
The SEC found that Columbia "allowed or failed to prevent hundreds" of accounts from engaging in short-term trading. These included the employees of Columbia's then-parent company, FleetBoston Financial Corp., and affiliated entities, who were frequently trading through Fleet's 401(k) plan, says the SEC order. FleetBoston was acquired by Bank of America in 2004.
As part of its settlement, Columbia appointed an independent consultant -- Lawrence Hamermesh, a professor of corporate and business law at Widener University School of Law in Wilmington, Del. -- to determine how to distribute the settlement money. It is his report that showed the extent of small-investor rapid trading. The report can be found at www.sec.gov/divisions/enforce/claims/columbiamanage.htm1.
Prof. Hamermesh declined to comment on his analysis.
A majority of the timing took place in mutual funds that invest in international and small-company stocks. In its simplest form, it works like this: U.S. stocks rally, and an investor has a hunch it will cause the Japanese market to rally overnight. He then puts some money in a fund that invests in Japan. If his hunch was correct, the fund's net asset value goes up the next day and he cashes out, making a quick profit.
One study found that in 2001 there was at least some rapid trading of this kind in 90% of fund families, causing losses of about $5 billion to buy-and-hold investors, across all asset classes. The analysis was conducted by Eric Zitzewitz, an assistant professor of economics at Stanford Graduate School of Business, using fund flows and return data obtained from third-party research firms.
According to Mr. Zitzewitz, until now it has been difficult to tell exactly how much of these losses were caused by individual investors. To determine that, "You really had to get the individual trading data from each fund company" he says.
Write to Shefali Anand at shefali.anand@wsj.com2
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