Prudential Fined Again

[Jack]

http://www.nytimes.com/2006/08/29/bu...l?ref=business

Improper trading with regard to market timing, apparently condoned by top executives.

[Amy7]

Thanks, Jack. I just read the article, and I'm confused. What exactly was the illegal practice? I understand that they were hiding something from the mutual funds, but don't understand why they had to hide the fact that they wanted to trade in these funds.

[Jack]

The SEC has been craking down hard on mutual fund timing.

I guess the actual illegal item would be..

According to regulators, the four men concocted an elaborate scheme to facilitate as many as a thousand transactions a day for their hedge fund clients by going to great lengths to disguise the origins of the trades.

The article could have done a better job explaining.

Most insurance companies have cracked down on agents and others involved in market timing activities. It's been difficult because most companies didn't have a mechanism to track this activity. It's also difficult because most contracts and prospectuses (sp?) didn't have language against market timing.

[Gandalf]

The biggest mutual fund abuses (which may not have applied in the Prudential case) were in International Funds. I don't know the exact mechanics, but the intent of mutual funds is that transactions are done up until some time (say 5PM), then all transactions are executed at that day's price. In particular, if the stock market happened to go up 2% between 10 AM and 4PM, a investor buying into the fund at 10AM pays the same price as one investing at 4PM, which is fair since the fund doesn't actually invest the its "buys" during the day. It is obviously a different ball game entirely if the 5PM price of a Japan fund is 10.00 per unit, you know the Japan market is up 2% by 8PM (so that units of the fund should be worth 10.20 per unit), and you let an investor contribute money at 8PM at the 10.00 price.

There is also the problem (which may not apply in the Prudential case) that frequent trading hurts all investors, since the transaction costs are borne by the fund and depress the values of all shares slightly. If you disclose the trading rules, and some people choose to trade more often than others within the rules, that's fair. If you tell them all the "rules", then don't apply them to large investors, then the small investors are being hurt compared to what was disclosed about the fund. (The situation is even worse if you do enforce the rules on the small investors).

[JoJo]

Its been a few years, but I remember some VUL policies at my old company where a broker was actively market timing & it wasn't just international funds that made his clients rich(er).

Since the fund prices were only set at the end of the day, any trades on Tuesday would be purchased at end of Monday prices. So, if he saw that the market was up on Tuesday, he'd move the money over to aggressive/tech/index funds around 3pm. On days the stock market was down, he'd move the money over to the money market fund at 3pm.

He was doing this on some policies of significant sizes and had DOUBLED their money in a year the stock market was down over 10%.

This hurts the people who are in the funds for longer durations because, for example, there is $10 million in a fund at the beginning of the day and the fund earns 2% that day ($200,000). Now, market timers move $2 million into that fund at the end of the day. So, the 200,000 gain has to be spread out over $12 million rather than $10 million, reducing the gain on those that were rightfully in the fund at beginning of day to 1.67%.

Finally, when he & others were caught, the company added language to their product prospectus and forced them to do fund changes in the mail after a certain number of trades had occured in a given year to reduce market timing.

[Gandalf]

Originally Posted by JoJo

Its been a few years, but I remember some VUL policies at my old company where a broker was actively market timing & it wasn't just international funds that made his clients rich(er).

Since the fund prices were only set at the end of the day, any trades on Tuesday would be purchased at end of Monday prices. So, if he saw that the market was up on Tuesday, he'd move the money over to aggressive/tech/index funds around 3pm. On days the stock market was down, he'd move the money over to the money market fund at 3pm.

Letting anyone do transactions Tuesday at Monday's closing price is illegal under the SEC's "forward trading" requirement.

This inset box on this page indicates why international funds could be subject to abuse.

TIME-ZONE ARBITRAGE

Sophisticated investors use a strategy known as time-zone arbitrage to trade in and out of mutual funds across international time zones. How it works:
A U.S. fund manager invested in Asian shares calculates his fund's net asset value at 4 p.m. New York time, up to 14 hours after the last markets in Asia close. That can produce a "stale" price.
On Oct. 28, 1997, the Hong Kong market index fell 14% but U.S. markets rallied later that day. Fidelity recalculated its Hong Kong and China fund to reflect the U.S. rebound. But Colonial Newport Tiger Fund, invested in many of the same stocks, did not recalculate, and its shares sold for an 11% discount.
The Securities and Exchange Commission does not require funds to address "stale" pricing. It says an adjustment should occur after a "significant event" but does not dictate how, or even if, a price must be recalculated, and most funds are unable to calculate such changes more than once a day.
Source: USA TODAY research

That Oct 28 situation would be a rarity, but a 2% change between the market closing price in Japan and the perceived value in New York 14 hours later would not be so rare.