Empire of the Fund: The Way We Save Now by Birdthistle William A

Author:Birdthistle, William A. [Birdthistle, William A.]
Language: eng
Format: azw3
Publisher: Oxford University Press
Published: 2016-05-31T16:00:00+00:00

The Legality and Illegality of Market Timing

Because of these administrative and economic costs, many fund managers voluntarily converted market timing from a legal practice into an illegal one. In a state of nature, market timing is not illegal per se.22 As a general principle of investing, many active investors unabashedly attempt to time their purchases and sales of securities. And inasmuch as markets are governed by cycles, many investors might reasonably attempt to time those cycles, also.

Indeed, when Eliot Spitzer and other prosecutors announced investigations into the illegal market timing of mutual funds, some confusion arose because of the perfectly innocuous connotations of the term in ordinary investing parlance. As the details of these inquiries in mutual funds emerged, however, pejorative implications attached themselves to the time-zone arbitrage we have been discussing. But, more pertinently, we learned that it was the investment advisers themselves who had converted legal market timing into an illegal practice.

How can private parties do that? Quite simply, as it happens, by imposing their own rules disallowing market timing in their funds. Once an investment manager prohibits market timing and publishes that proscription in the fund’s legal prospectuses, any disregard of that policy is not only against the fund’s private rules but now also a violation of federal securities laws. Operating a mutual fund in a way that violates its public prospectuses is illegal.

Many mutual fund managers voluntarily and publicly adopted anti–market-timing policies because they reasonably believed that long-term investors preferred to be insulated from the harmful costs of market timing in their funds.23 But market timing can be an extremely lucrative practice for hedge funds. Eric Zitzewitz, professor of economics at Dartmouth College, has calculated that market-timers made profits of $4.9 billion each year at the expense of long-term investors.24 So, not surprisingly, many hedge funds were willing to pay generously for the ability to continue doing it. And they found a number of mutual fund managers who were willing to violate their own policies, to harm their own long-term investors, and to incur the aggravation of market-timing transactions costs. For the right price.

In essence, hedge funds paid mutual fund managers to poach in the mutual fund’s game reserves. By advertising their funds as anti-market timing, the fund managers successfully attracted long-term investors. But by then allowing market-timers to operate in those funds, the managers were granting hedge funds carte blanche for a turkey shoot.

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