'Market timing' probed as bilking investors

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As regulators deepen their probe into illegal trading by mutual funds, investors are learning more about potentially shady practices that can hurt their returns. Fortunately, they have ways to protect themselves.

In recent weeks, New York Attorney General Eliot Spitzer and the Securities and Exchange Commission have said they are investigating "market timing" of fund shares, a practice they say costs investors billions of dollars.

Investors often seek to time the market by trying to buy individual shares when they are low and selling when they are high. But market timing in mutual funds, or short-term, "in and out" trading, can be particularly harmful because the transactions often hurt other investors in the fund.

"It's a big concern," said Roy Weitz, publisher of FundAlarm.com. "Market timing is basically a hidden expense ratio. If you have a 1 percent expense ratio and a 1 percent loss to market-timing, that's a lot of money."

Still, defending against market timing can be tricky. That's because the practice is legal unless a fund's prospectus bans it. In addition, firms don't always offer safeguards as they seek to attract, rather than discourage, more assets.

Analysts say the best approach is for investors to find firms that prohibit timing and offer protections, particularly for international funds, where market timers often seek to take advantage of time differences for quick gains.

In addition, they say other factors such as fund-expense costs or a manager's length of tenure could offer signals to investors as to whether companies are putting their best interests at heart.

"The basic issue is one of trust. You have to feel good about the firm you're investing with," said Jeffrey Ptak, mutual fund analyst at Morningstar Inc.

Mr. Spitzer has accused hedge fund Canary Capital Partners LLC of market timing involving Bank of America, Janus, Bank One Corp. and Strong Financial Corp. funds. Alliance Capital Management Holding LP also suspended two employees for reputed market-timing transactions.

Market timers can hurt longtime investors in several ways. A series of transactions in and out of a fund can increase the commissions managers must pay to buy and sell securities; that eats into returns. Quick withdrawals also can force managers to sell winning investments, or managers anticipating many withdrawals may hold a larger cash reserve than necessary.

International funds in particular tend to offer good market-timing opportunities because of the time differences. Funds typically calculate their share prices based on the value of their securities once daily after the 4 p.m. Eastern time close of markets; that means an investor could trade in a U.S. fund holding Japanese shares even though the Tokyo market closed hours earlier.

So if U.S. stocks are rallying, an investor can buy shares in that international fund on the expectation that Tokyo will rally the next day, and then make a quick sale for profit.

To combat that, some firms such as the Vanguard Group, T. Rowe Price and Capital Research & Management Co. use "fair-value" pricing to factor in more up-to-minute information on major market-moving days. So if U.S. stocks plunged, investors couldn't as readily take advantage of the time difference to escape a likely sell-off in the Japanese markets the next day.

"I would be more vigilant about timing if you had a fund with significant foreign holdings or holdings with potentially less liquid, such as a small-cap or high-yield fund," Mr. Ptak said. "Usually you can find out if firms do fair value pricing either in the prospectus or in the annual report."

Other defenses include redemption fees and limits on trades. Vanguard, for example, imposes fees, including a 2 percent charge on international funds held less than two months as well as fees for sector funds to deter short-term trading.

The company also places trading restrictions that prevent investors from moving out of an index or international fund more than twice a year, according to Vanguard spokeswoman Rebecca Cohen.

ASSOCIATED PRESS