What Is Mutual Fund Timing?
Mutual fund timing is a legal but often discouraged practice whereby traders attempt to gain short-term profits from buying and selling mutual funds at the end of the trading day in order to benefit from the differences in net asset value (NAV) closing prices and the closing prices in the market of the individual stocks inside the fund.
- Mutual fund timing is where investors seek to profit from short-term differences between the closing NAV of a mutual fund and the market prices of the fund's component stocks.
- The practice is detrimental to long-term investors since the additional redemptions of shares by short-term profiteers generates excess fund management costs.
- While it is not illegal, fund timing is frowned upon be regulators and mutual fund companies can be fined for late trading and may bar those who engage from the practice from investing in their funds.
An Introduction To Mutual Funds
How Mutual Fund Timing Works
Mutual fund timing is legal and can help investors to profit from trading opportunities or trades enacted at opportune times of market changes. However, mutual fund timing is often discouraged by mutual fund companies because of the negative affects it has on a fund.
Since mutual funds are managed as a pooled structure, invested and withdrawn capital must be deployed by the fund manager. Instead of an investor buying into a stock directly for immediate ownership, mutual fund managers must disperse invested capital across a portfolio of investments. In the same regard, mutual fund managers must sell against the fund to provide for redemptions in cash to shareholders.
Mutual fund timing therefore has a negative effect on a fund's long-term investors, since the processing of short-term transactions increases transaction costs, causing higher operational expenses. To mitigate mutual fund timing and its added costs, most mutual funds impose a short-term trading penalty, known as a redemption fee. Redemption fees are charged upon the sale of shares that are not held for a minimum period of time, which generally ranges from 90 days to one year.
Regulation and Investigations
Mutual fund timing is closely monitored by both regulators and fund companies. In September of 2003, some mutual fund companies were investigated for permitting traders to "time" mutual fund purchases. Fund companies were charged with allowing late trading, which is the processing of shares after the market’s close at the day’s NAV rather than transacting at the next day’s price. Settlement required these companies to more cautiously account for late trading and market timing with greater controls for forward price transactions.
Overall, when legally transacted, market timing can be a profitable way to add value. Just as with stocks, mutual funds may have opportunities for short-term gains that make trading beneficial for profit. Investors can use quantitative modeling techniques to identify mutual fund arbitrage opportunities or they may generally base investment decisions on qualitative observations. With these techniques, market timing can be legal when transacted appropriately. It can also generate profits even after redemption fees.
In the case of closed-end funds and exchange-traded funds (ETFs), market opportunities may be easier to identify. Closed-end funds and ETFs trade throughout the day, often at discounts to their NAV, which provides for market timing opportunities. ETF arbitrage through market timing is actively followed and often mitigated by ETF authorized participants who have the authority to monitor prices and issue or redeem shares.