A Distinct Chill Has Descended On Market Timing Relationships
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Mutual funds and issuers of variable insurance products have been grappling with the adverse effects of market timers for several years.
In the past, the responses have been tempered by the love-hate relationship between funds and insurance products issuers on the one hand and market timers on the other.
However, a variety of forces have now upset the balance so that a distinct chill, if not hate, has descended. What is this about, and whats being done about it?
To many fund managers, market timers' adverse impact on performance now outweighs their asset gathering benefits. Thats because frequent short-term trading boosts the funds' transaction costs and requires fund managers to keep more cash uninvested to meet redemptions. If they dont keep enough cash on hand for redemptions, they may be forced to sell holdings at times and at prices that adversely affect performance.
An additional negative effect is the increase in the tax liability of shareholders. A funds sale of appreciated stock results in capital gains taxable to shareholders, even if the holders have not sold their fund shares or if the funds' current price is lower than the purchase price.
The ill effects of market timing are felt most by international funds. Thats because market timers have been engaging in what is known as "time zone arbitrage."
Here, the timers bet, with some degree of success, that overseas markets will respond favorably to a rise in markets in the United States. The timers buy a mutual fund that invests in foreign stocks, expecting those stock prices will rise based on an upswing in the U.S. markets. They also dispose of the funds in anticipation of a downturn in the foreign markets and related stocks the fund holds.
Other mutual funds, including municipal bond funds, have also felt victimized by more traditional market timing activities.
In the past, mutual funds responded in tempered ways to short-term trading by market timers. Positive performance in the bull market of the 1990s was readily achievable, the markets were less volatile, globalization of the markets was a buzz phrase and less of a reality, and timers had not thought of this gambit.
Fund families and variable insurers responded by monitoring and identifying market timers and dealing with them individually. Some also limited the right to buy back into the fund following a short-term purchase and sale.
Those techniques have proven to be costly. So, in the last 18 months, a marked trend toward imposing redemption fees has emerged as the favored solution. By March 2001, a recent study says, about 600 funds had implemented such fees, up from roughly 300 funds 18 months ago. Even so, the verdict is not yet in on the overall benefit of redemption fees.
