Commentaries

Recent allegations levied against the mutual fund industry have no doubt harmed the industry's reputation. However, I am not sure that much good has or will come from the investigation carried out by industry regulators, nor am I sure that justice was served in the end. A few points need to be clarified.

First, these investigations took place in Canada largely, if not entirely, because of a probe in the US surrounding late trading practices. Late trading is a serious issue in that some investors are given preferential treatment over others. This took place in the US. It is virtually impossible, given the infrastructure through which mutual funds are transacted in Canada, for it to have happened here. In the US, some very large investors were allowed to purchase funds long after the close of markets and therefore, essentially were buying yesterday’s winners. This would harm mutual fund investors who did not have such privileges. As the OSC (Ontario Securities Commission) later would report:

"In the probe, OSC staff did not uncover any evidence of late trading."
OSC press release, Dec. 14, 2004.
The unprecedented settlements that flowed from the investigation of fund companies – in excess of $200 million paid by fund companies to the unitholders of their funds – were in response to charges of market timing. Market timing is essentially frequent trading activity, sometimes involving the purchase and sale of a mutual fund by a unitholder more than ten times per month. Large institutional investors were found to have engaged in market timing during the years 1999 through 2003. By trading large amounts with frequency, funds bore a transaction cost that was spread evenly among the units of a fund. Potentially, this means that long term investors in the funds are incurring costs from the activities of the market timers. Regulators have taken issue with this. Despite the fact that fund companies in many cases either charged a fee to the market timing investors that was returned to the funds, or prohibited them from further market timing activities after warnings to cease were not heeded, fund companies were fined for failing to sufficiently limit the practice and safeguard all investors. As an example, AGF (who made $700000 in fees for dealing with the accounts of their market timers) settled with regulators on a penalty of over $29 million, most of which will be returned to unitholders who held the fund at the relevant times.

It is vital I think to point out that market timing is not, and was not, illegal. In fact, any one of my clients could today carry out the same practice. However, I suspect that small investors would be sooner warned to cease the practice, and perhaps that is where the concern of regulators lies.

The large investors who carried out these market timing transactions and the bank-owned brokerage houses who processed these transactions on their behalf have largely escaped any penalty. While these investors profited from their trading, some of their profits were due to market gains, and not from harm done to other unitholders. Again, using AGF as an example, in the OSC report it was set out that:

"…total profit realized in AGF Funds by the Market Timing Traders was approximately $47.9 million (not all of the profit realized by the Market Timing Traders was from frequent trading market timing transactions, and the profit realized by the Market Timing Traders does not equate to harm to other investors in the AGF Funds)."
I am not sure that justice is properly served if only the fund companies are held responsible for this activity. One positive result is that the scrutiny on this subject, and large fines, have put a stop to such activity. The fund companies settled quickly to preserve their reputations and remove the issue from the public discourse as quickly as possible and faster than public hearings and defence would allow. I am not sure that I agree with their strategy as it pertains to their public image.

According to the investment industry publication, Investment Executive,

"The vast portion of the profit from this trading went to the institutional investors that made the trades. And the OSC has indicated it can’t touch them because market-timing is not strictly against the rules. But market-timing wasn't strictly against the rules for the fund companies, either."
The parties that profited the most (and if any harm was done to the average investor, it must have been done by those who profited most) will not pay a price. The fund companies were a conspicuous target and, reported by Investment Executive, "One industry executive whose company was caught in the case says his company felt compelled to settle: fund firms that aim to serve retail investors have too much reputation at stake for a protracted hearing."

Effective regulation prevents harmful practices from occurring. Less effective would be regulations that punish wrongdoing after the fact, although this will provide retribution, restitution and deterrence in the service of justice. What I fear is regulation or punishment whose intent may only be cosmetic.

For mutual fund investors, what can be said on a positive note is that the amount of abuse and harm, if any, was terribly small given the $400+ billion of the industry; that fund companies had procedures in place prior to all this to limit or eliminate any harm to unitholders or to make restitution to the fund; and that the practice had largely been eliminated prior to the probe by regulators.

Perhaps what we need most is a regulatory body that takes a leadership position, rather than a reactionary one if we are to give investors complete faith in the financial services industry. In the meantime, investors can expect payments associated with the negotiated settlements likely some time this year.

Alan Cameron

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