Gary D. Halbert President & CEO

On September 3, we read in the financial papers that a large hedge fund had agreed to pay $30 million in restitution of illegally obtained profits from after hours mutual fund trading, plus a $10 million penalty for doing so. The hedge fund noted in the announcement was Canary Capital Partners LLC and is reportedly part of a much larger investigation into such practices by New York’s Attorney General, Eliot Spitzer.

Canary (and perhaps other large hedge funds) allegedly obtained special trading opportunities with several leading mutual fund families - reportedly including Bank of America’s Nations Funds, Banc One, Janus and Strong - by promising to make substantial investments in various mutual funds offered by these firms.

The special trading opportunities, in this case fraudulent trading opportunities, consisted primarily of so-called “late trading” of mutual funds after the stock markets close at 4:00 eastern time. If you or I, for example, want to make a purchase or sale of a mutual fund, we have to get our orders in to the fund family before the close of the markets, sometimes 30 minutes or more before the markets close. If you or I place our order after the markets close at 4:00 today, then we don't get that order filled until tomorrow at the 4:00 closing price.

In the case of Canary, the mutual funds noted above (and possibly others) allegedly allowed Canary (and others) to place its orders AFTER the markets closed and still get the closing price for the same day. As you know, there are frequently announcements just after the markets close that can have significant effects on the markets the following day. Allegedly, these hedge funds would trade on this after-market information and reap big profits the following day.

Allowing large hedge funds to trade after hours is illegal and it serves to reduce profits and/or increase losses to the other shareholders of the mutual funds!

Why Would The Fund Families Do This?

What is most surprising to me is that these very large mutual fund families would have engaged in these illegal practices, in the first place, and apparently for several years in some cases. The answer, as usual, is making more money. According to information disclosed by Eliot Spitzer, Bank of America made $2.25 million per year from these companies and/or hedge funds in special payments and other incentives.

The investigation of illegal trading at mutual fund families is ongoing. More fund families may be cited in the weeks ahead. Obviously, as this information is made public, it will be bad news for the fund families that are cited. For example, Morningstar has already released a statement advising investors to move their money out of the four fund families (noted above) named by Spitzer in his complaint. If the scandal is larger and if other mutual fund families are cited, then Morningstar will be hard pressed not to offer the same advice for them.

“Market Timing” - A Bad Choice Of Words

When NYAttorney General Eliot Spitzer made his announcement on September 3, he referred to this illegal after-hours trading as “late trading” which is accurate. But he also criticized the hedge fund’s use of short-term trading, and in doing so used the term “market timing.” This has led to a flurry of misplaced negative discussion about market timing. As a result, I want to take this opportunity to set the record straight.

What these funds were doing is NOT an accurate characterization of market timing, in my opinion. The short-term trading of mutual funds that Canary (and apparently others) was doing is not illegal. It was the after-hours trading that was illegal. The term market timing, as most of you reading this know, does NOT relate to the fraudulent, after hours trading that was discovered by Spitzer's investigation.

Some mutual funds discourage short-term trading because it can cause problems for the fund managers if large blocks of money move in and out of the funds frequently. So, some funds actually prohibit such short-term trading in their prospectuses, and they retain the right to redeem (force out) customers who trade too frequently. The four fund families noted above actually had such prohibitive policies on short-term trading in their prospectuses.

Mr. Spitzer said the funds operated under a “double standard,” in that the Canary fund and apparently other big players were allowed to execute short-term trades even while everyone else was precluded from doing so. Again, the problem is not that short-term trades are illegal. In fact, there are numerous fund families such as Rydex, ProFunds and others that actually welcome short-term trading and were specifically designed to accommodate such rapid trading.

In addition to allowing short-term trading when their stated policies prohibited such practices, the funds named above also allegedly allowed Canary and others to place such orders after the close of the markets, which is clearly illegal. This is not market timing as we all know it. Yet due to the latest publicity, Ifeel the need to make the distinction.

Market Timing In The Traditional Sense

As you know, market timing is a strategy that involves moving in and out of the market periodically in an effort to miss portions of the downward moves in stocks, while being in the market for significant portions of the upward moves. In theory, market timing would allow investors to reduce their risks during downtrends in stocks and bonds, while still earning at least market rates of return on the upside. Market timing is practiced by many individual investors and many professional Investment Advisors. It is in fact a very legitimate and legal investment strategy. However, because Mr. Spitzer chose to use those words - “market timing” - in his announcement, some investors who are not familiar with traditional market timing have confused it with the fraudulent activities discussed above. Nothing could be further from the truth!

To help combat the perception that market timing is somehow illegal, the Society of Asset Allocators and Fund Timers, Inc. (SAAFTI), an association of Registered Investment Advisors who practice market timing and other active management strategies, issued a rebuttal to Mr. Spitzer’s use of the term “market timing.” The following excerpt from SAAFTI’s press release sets the record straight:

“Members of SAAFTI are recognized, registered and regulated by the U.S. Securities and Exchange Commission and individual state securities administrators. Their trading strategies are acknowledged by the regulators and their practices are regularly reviewed for compliance with state and federal regulations. Many have used timing strategies for over three decades… There is absolutely no relationship between the strategies employed by these investment firms -- who conduct their investment management business in accordance with the rules promulgated by the SEC and state regulatory authorities -- and the example cited by Mr. Spitzer. To draw such an inference is both irresponsible and a disservice to the investing public.”

I could not agree more! So, if you should read negative comments about market timing, within the scope of the recent mutual fund/hedge fund scandal, just keep in mind that this does not refer to market timing as we practice it. Also, keep in mind that this latest flap over market timing, however misplaced, plays right into the hands of the mutual fund industry and to some extent, Wall Street. The mutual fund community (with the exception of Rydex, ProFunds and others who invite market timing) and to some extent, Wall Street have criticized market timing - as we practice it - for years. They have continually argued for a “buy-and-hold” strategy. But you know differently, especially in light of the September issue of F&T wherein I presented “ The Definitive Case For Market Timing.” Market timing, as we practice it, is a very valid investment strategy, especially in the market environment we have seen over the last three years of the bear market.