What Is Mutual Fund Timing?
Mutual fund timing is a legal but often discouraged practice whereby traders attempt to profit from short-term differences between the price of mutual funds and the individual securities in those funds. This is possible because mutual fund prices only change once per day.
Mutual fund timing is often associated with late-day trading, when traders buy mutual fund shares at an older price after the fund's net asset value (NAV) has already been recalculated. Unlike late-day trading, mutual fund timing is not necessarily illegal, but it can harm long-term investors by increasing the mutual fund's management costs.
- Mutual fund timing is when 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 securities.
- The practice is detrimental to long-term investors since the additional redemptions of shares by short-term profiteers generate excess fund management costs.
- While it is not necessarily illegal, fund timing is frowned upon by regulators and mutual fund companies.
- Mutual fund timing can be illegal if it violates the policies set out in the prospectus of a mutual fund or gives preferential treatment to some investors over others.
An Introduction To Mutual Funds
How Mutual Fund Timing Works
Mutual fund timing works because of a key difference between mutual funds and stocks. While stock and bond prices fluctuate over the course of a trading day, mutual funds only update their prices once per day, after the close of the stock market. In the United States, this is usually between 4 pm and 6 pm EST.
This lag allows short-term traders to profit from swings in the stock market before they are reflected in mutual fund NAVs. If a stock experiences a sharp price rise at the opening of a trading day, traders will have several hours to set buy orders for mutual funds that invest in those stocks, knowing that the funds will not recalculate their NAV until market close.
Mutual funds tend to discourage timing because it increases their management costs, to the disadvantage of long-term investors. Most funds have rules to limit short-term trading, such as additional redemption fees and limitations on round-trip trading.
Negative Effects of Mutual Fund Timing
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 effects 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 can range from 30 days to six months. They may also charge a short-term trading fee for selling shares too soon.
While mutual fund timing is not inherently illegal, some fund managers have been subject to regulatory penalties for mislabelling late trades or violating their company's policies.
Historical Example of Mutual Fund Timing
One of the most famous mutual fund scandals was revealed in 2003, when the New York Attorney General began investigating market timing and late-day trading in the mutual fund industry. In some cases, traders who had been barred for fund timing concealed their own identities to continue trading. In others, mutual fund managers were accused of giving preferential treatment to some buyers, by allowing short-term trades that were forbidden under the rules of their own funds.
One investment bank, Bear Stearns, even had a specialized "timing desk" that helped brokerage customers make late trades, or cancel unprofitable trades the next day. They also helped hedge funds evade the blocking systems that had been established to prevent timed trades.
Following investigations by the New York Attorney General and the Securities and Exchange Commission, more than a dozen mutual fund companies paid fines and restitution totaling $3.1 billion. Many employees also lost their jobs.
The total amount paid out by mutual fund companies during the 2003 mutual fund scandal.
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.
Is Mutual Fund Timing Illegal?
Mutual fund timing is not illegal by itself unless it violates other securities laws or investor protections. For example, many mutual funds have rules to discourage fund timing listed in their prospectus, with additional costs or barriers to short-term traders. A fund manager who selectively allows some traders to break those rules could be breaking the law. Likewise, if a mutual fund or brokerage bars someone for trading too frequently, it is illegal for that person to use deceptive means to continue trading.
What Is the Difference Between Mutual Fund Timing and Late-Day Trading?
Late-day trading, or late trading, is when a trader buys mutual fund shares after the market has closed, based on the previous day's prices. For example, a trader who buys a mutual fund at 4:30 p.m., using the price at 4:00 p.m., is engaged in late trading. A brokerage or mutual fund that knowingly permits this behavior is also culpable. Unlike mutual fund timing, late-day trading is explicitly prohibited under federal securities laws.
What Are the Rules for Trading Mutual Funds?
Mutual funds are very different from buying ordinary stocks and bonds. Unlike the stock market, mutual funds can only be traded once per day–usually at market close. At that time, the fund's net asset value is recalculated based on the closing prices of the fund's component securities, and a new price is set for the following day. Mutual funds also charge management fees, to defray the cost of running the fund, as well as sales loads or purchase fees. There may also be redemption fees or short-term trading fees, to discourage fund timing.