Frequent Participant Trading Elicits Fund Provider Response

Between 2011 and 2013, T. Rowe Price Group instituted permanent bans against 1,300 American Airlines employees and sent warning letters to another 800 employees about their potentially disruptive trading patterns (see “Airline Employees Banned from Trading Certain Funds”). The 1,300 employees are prohibited from trading among T. Rowe Price funds, but still permitted to trade among the other investment choices in their plans. A recent article by CNN Money notes certain participants of some American Airlines’ 401(k) plans have been banned from trading into certain funds, some for a finite period of time and some for life.

The issue with the airlines’ employees centers around newsletters that offer trading recommendations to employees. The EZ Tracker LLC newsletter has been noted, as well as 401k Maximizer, which caters to employees of not only American Airlines, but also Southwest, U.S. Airways and Delta.

Though the instances reported in the media have been about airlines’ employees, fund companies may institute these restrictions when employees of any industry frequently trade within their employer-sponsored retirement plans. Vanguard has given warnings to employees of Southwest Airlines. When asked if there was a regulation requiring them to halt such trading, Linda S. Wolohan, a Vanguard spokesperson, told PLANADVISER, “It’s not primarily a regulatory situation. The prospectus for our funds gives Vanguard the authority to take action if there’s frequent trading or purchases by any type of investor, whether or not through a retirement plan, that we determine to be harmful to a fund.”

Wolohan explains that Vanguard took such steps only after exhausting other avenues to resolve the issue, such as repeatedly asking the newsletters to stop making recommendations on Vanguard funds.

“The issue is large, unexpected transactions that can also be the result of frequent trading,” says Wolohan, who is based in Valley Forge, Pennsylvania. “These transactions can be disruptive to all shareholders in a fund because they can affect the fund manager’s ability to fully invest cash or to liquidate securities in a timely or cost-effective manner.”

She explains that it is the unexpected nature of these transactions that is the crux of the issue, adding, “If we know well in advance of a scheduled plan ‘event’ that will trigger the need for massive transactions—for example, a 401(k) plan is substituting one or more funds in its investment lineup with other options, thus necessitating the need to sell the assets of participants in the old funds and buy the new ones—we can plan to execute those trades at the lowest possible transaction costs.”

However, says Wolohan, if the fund manager does not know about these large transactions in advance, they cannot plan accordingly. “All transactions in 401(k) plans are aggregated at the end of the day, and we are obligated to sell at the previous day’s net-asset value,” she says. “In that time, prices may have changed, which can hurt the fund’s value and harm all shareholders.”

Wolohan adds, “Some of these types of newsletters believe they can best serve their subscribers by recommending that they move from an existing fund to the ‘hot’ fund of the moment. This can lead to frequent trading. But frequent trading can create transaction costs—and possibly tax consequences for non-retirement investors—that the rest of the shareholders in the fund must absorb.”

Wolohan explains that Vanguard is an advocate of a long-term investing approach, with research showing some of the most significant factors that derail an investment strategy are behavioral. These factors include the failure to rebalance, the allure of market-timing, and the temptation to chase performance. The latter two, she notes, are the issues for employees who are frequently trading.

“We try to safeguard our long-term shareholders from subsidizing frequent transaction activity by others,” she says. “We do this through our frequent trading policy, which restricts fund investors from making rapid out-and-back round trips. It prohibits shareholders who redeem or exchange any amount out of a Vanguard mutual fund from purchasing or exchanging, by telephone or online, back into the same fund for 60 calendar days. The rule is designed to ensure that investors think long term, while still allowing them to effectively manage their assets.”

As to whether there is anything that plan sponsors need to be doing to make these investment restrictions clearer to participants, Wolohan notes that this is not a widespread issue in the 401(k) space, so most plan sponsors probably do not need to worry about it.

“But, if there is a problem, fund companies will work with the sponsor, who will likely use plan communications to educate the participants on the issue,” she says.