IMHO January 12, 2008

IMHO: Trading Places

Back in 2003, when then-New York Attorney General Eliot Spitzer launched his investigation into mutual fund trading practices, two distinct areas were highlighted.

Reported by

Nevin E. Adams

late trading, which was illegal on its face (particularly so when facilitated by the fund companies themselves), and market-timing, which, as we were reminded in a parenthetical comment in nearly every story regarding the scandal, was not (though nearly every fund prospectus claimed to discourage such patterned trading and promised to take steps to deter it).

That distinction was frequently glossed over in the coverage that followed—and the settlements that ensued. When all was said and done, a large number of chastened fund complexes had forked over a large amount of money (much of it to the coffers of the Empire State) and agreed to adopt new controls and procedures designed to ensure that the wrongdoing they never admitted to doing never happened again. So much commotion was raised, in fact, that the Securities and Exchange Commission was roused from its slumbers—just in time to adopt a “solution’ to the problems resulting from the not-illegal-but-nonetheless-apparently-troubling practice of market-timing. Of course, the solution—initially set forth by a trade group that represents the mutual fund industry—was already available to those fund companies. But now, thanks to the codification in SEC Rule 22c-2, even the most casual mutual fund investor—including those who do so only via their 401(k) plan—has been forced to be aware of redemption fees—and we’re not just talking about cases of quick in-and-out, round-trip trades, either.

Setting aside what, IMHO, is still an absurd result, it’s all old news by now. Been there, done that, bought the T-shirt….

Here We Go Again

That’s why it’s been interesting to watch the debate over market-timing once again raise its ugly head—this time among the participants of the federal government’s own Thrift Savings Plan, or TSP. Apparently, there are a couple of thousand participants (out of a universe of 3.8 million in the TSP) who are trading “frequently’—and the TSP is taking steps to rein them in.

The Washington Post has reported that 2,018 participants who sold holdings in an international fund on October 24 had transferred in just a few days earlier (10/19). And, of that group, 323 participants were trading $250,000 or more. Moreover, during the previous 60 days, those 323 traders had made 5,804 exchanges in the international fund worth $1.9 billion, according to TSP officials (one participant has traded more than $1 million back and forth a number of times). These participants aren’t trading in mutual funds, of course, so the SEC’s 22c-2 strictures don’t apply.

Moreover, an analysis by fedsmith.com (a Web site devoted to federal workers) claims that those who bought in on 10/19 did so at $25.13/unit, and those who sold on 10/24 did so at $25.32/unit, making 19 cents per unit in just a few days. A feat that looks pretty good until you consider that, at 10/31, that particular TSP fund closed at $26.31.

But the TSP’s issue isn’t with the money these folks are making on those transfers. Rather, they are concerned about the cost impact of that activity on the folks who don’t trade; higher broker fees and transaction costs—especially in the international fund, where it’s more difficult for the TSP’s investment manager (BGI) to match buy and sell orders. They have—rightfully as fiduciaries, IMHO—expressed concern that a (relatively) few participants are driving up the costs for the vast majority who, like their counterparts in the private sector, never trade. Those trading costs stand out in the TSP, which enjoyed a total expense ratio of 3 basis points (that’s not a typo) in 2006. The trading costs for their international fund that year? Eight basis points (again, no typo). Now, those expense ratios may be a “problem’ that your average 401(k) would love to have, but we’re talking about a $235 BILLION dollar fund. So, in crafting a recommendation to deal with this situation, the TSP’s chief investment officer looked to—mutual fund practices in the 401(k) industry and the SEC’s mandate under Rule 22c-2 (see). Ultimately, unable to come up with a transaction fee that would be big enough to cover the trading costs, the TSP has decided to impose limits on the number of trades per month. Those limits—two per month—should be enough to satisfy anybody who isn’t trading funds for a living. Moreover, the TSP has imposed NO restriction on transfers from any of the funds to the G fund, the TSP’s most conservative option, to address the concerns of participants who might want to move their balances out of the way of some economic tsunami. More importantly, IMHO, it sends a message both to those participant-traders and to “everybody else.’

I also was struck by the TSP’s comparison of their solution with that adopted by the mutual fund industry. Though we frequently bemoan the bane of participant inertia, our industry has long been concerned about participants that would fritter away their day—and their balances—trading their retirement savings. That was the mantra against daily valuation in the first place, why we fretted over day traders in the middle of the tech-bubble, and, now, why a relatively few market-timers (setting aside for a minute that the incidents taken to task by regulators involved the complicity and/or active acquiescence by the fund companies; let’s face it, we all know the odds are against participant timers) have managed to burden an entire industry with an additional layer of costs, another complicated message, and random restrictions.

I can understand why the fund managers are in favor of these impediments. I’m (still) not altogether sure why the rest of us have been so willing to go along.

Footnote:

In the interim, a group calling itself TSPSHAREHOLDERS.ORG has launched a web site and a petition campaign to block the new transfer policies – and they have just under 3,000 signatures on that petition (one can’t help but wonder if it’s the SAME 3,000 that have been doing the frequent trading). They have some issues with the calculation of trading costs – and they claim that the big trading surge last October resulted in a “tracking error’ (basically a difference between the price at which transfers were credited and the real cost of the transaction) – and they claim that the tracking error accounted for 56 basis points in the favor of those who stayed in the fund (see http://tspshareholder.org/newsletters/Vol2_No2.html).

Now, what’s missing in that analysis, of course, is the reality that that tracking error COULD have cut the other way – and those left sitting in that investment fund could just as easily have been stuck with a loss. But then, that’s how free markets work. Some people win and others don’t (what’s also more than a bit ironic, IMHO, is that up until the past couple of years TSP participants could only transfer once a quarter).