The U.S. Securities and Exchange Commission (SEC) defines late trading as "the practice of placing orders to buy or redeem mutual fund shares after the time as of which a mutual fund has calculated its net asset value (NAV), usually 4pm (EST), but receiving the price based on the prior NAV already determined that day."

When mutual fund companies allow selected investors to make purchases after the share price has been determined, they give those investors an unfair advantage over other investors. This type of trading is illegal and has been since 1968, when the SEC adopted the "forward pricing rule." New York State's Martin Act paints the issue with a broader brush, forbidding fraudulent behavior, and it was used successfully to prosecute many of the nation's largest fund companies in 2003. Prior to 2003, the practice of late trading was widespread and mutual fund companies gave some of their favored institutional investors, such as hedge funds, the opportunity to buy after the prices had been set. Read on to learn more about late trading and how it affects individual investors.

SEE: The Daily Routine Of A Swing Trader

Why It Matters
A quick review of the mechanics of mutual pricing highlights the relevance of the SEC's definition: Mutual funds are priced once per day in a trading session. The price is set after the 4pm close of the financial markets. Investors placing an order to make a purchase any time during the trading day pay the price per share that is set at the end of the day. So, if you purchase 10 shares of a mutual fund at 9am, noon or 3:59pm, you will not know the price of those shares until after the markets close at 4pm. If you place a trade at 4:01pm today, the price you pay should be the price that will be set when the markets close at 4pm tomorrow.

Knowing the price is a major advantage because by looking at the futures market and/or after-hours announcements, investors can develop a strong idea about how the markets will open the next day. For example, international stocks that trade on exchanges located in foreign countries operate in different time zones and close earlier than U.S. markets. When the U.S. markets close higher than they opened, the odds are high that the foreign markets will rise when they open for business the next day. Similarly, if the U.S. markets and a given foreign market are both falling when the foreign market closes but the U.S. market rebounds to close higher at the end of the day, it is extremely likely that the foreign market will open higher the next morning.

Knowing how the U.S. market closes, and being able to buy after that close, significantly increases the odds of locking in short-term profit when the market reopens, particularly when the fund company agrees to let favored clients decide whether to sell after the fund's price has been calculated. If profit has been made, shares are sold and gains are realized. If not, the shares are held until a guaranteed profit can be realized.

The same logic applies when news is released after the market closes. If, for example, the technology sector announces record profits, tech stocks should rise the next day. Buying shares in a technology fund at the previous day's price virtually guarantees a gain the next day.

Impact on the Little Guy
Because every investor in a mutual fund shares in the cost of all transactions that take place in the fund, investors that don't have access to special deals with the fund company are essentially paying to subsidize trades for institutional investors. While the little guys lose money, the big guys lock in guaranteed profits. According to an academic paper entitled "How Widespread Was Late Trading In Mutual Funds?" (American Economic Review, 2006) by Economics Professor Eric Zitzewitz, such activity has a cost to mutual fund investors in the range of up to $400 million annually. Sadder still, many of the little guys participate in the financial markets as a means to fund their retirement, so they invest for the long term, while the institutions make short-term trades, racking up expenses for the fund and locking in profits.

The Bottom Line
The late trading scandal gave a black eye to the mutual fund industry, which had previously represented itself as a haven for individual investors. Prior to uncovering the misdeeds, which had been taking place for years, mutual funds had a clean reputation, which stood in contrast to Wall Street, where scandal upon scandal had been unearthed until misdeeds were so common that they were practically expected.

Why did fund companies let institutional investors profit at the expense of the other mutual fund shareholders? The answer is simple: greed. Despite the billions of dollars the industry brings in each year and all of the good faith it had built with investors, the prospect of a few extra dollars in the till was enough to convince them to break the law and perpetrate fraud against their own clients.

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