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How we probed the churn patterns

Rapid trading in mutual funds is highly profitable for professional traders. And while it isn't illegal, fund managers have a fiduciary duty to investors to ensure that the fund is run with their best interests at heart. Rapid trading is clearly not in the best interests of long-term investors because it reduces a fund's returns.

The practice -- where traders such as hedge funds attempt to exploit price discrepancies in overseas funds where prices can be hours out of date because of time-zone differences -- has been prevalent in North America. U.S. regulators launched a crackdown in 2003. But what about Canada?

Report on Business examined the activity in international equity funds managed by Canadian mutual fund companies, using data available for 2000, 2001, 2002 and 2003. We excluded startup funds and funds for which there were no data for a full year.

The monthly churn rate for each fund -- a measure of all the money flowing in and out of it -- was calculated by adding four numbers: gross sales, redemptions, transfers in and transfers out. Transfers consist of money that moves from one fund to another within the same company.

An annual churn rate was then calculated by dividing each fund's total money flows for the year by its average assets.

These figures were calculated for about 500 funds in each of 2003, 2002 and 2001, and about 450 funds in 2000 -- a year in which there were fewer international funds.

We then examined every fund with a churn rate of 100 per cent or more. A rate of 100 per cent means cash equal to the dollar value of average assets flowed in and out of the fund.

Eric Zitzewitz, an assistant professor of economics at Stanford University's business school, whose research has been cited by U.S. investigators, says he would start to question whether market timing is going on in any fund with a churn rate greater than 100 per cent.

Report on Business determined that the main mechanism for rapid trading was transfers within the same fund family. We looked for funds with roughly similar and erratic monthly churn patterns.

A typical example is the CI Global fund, which had a churn rate of 554 per cent and average assets of $1.1-billion in 2003. That year, $2.85-billion was transferred in from other CI funds, and $2.87-billion was transferred out. By contrast, sales were only $117.2-million, while redemptions totalled $148.8-million. The monthly churn rate ranged from 34 per cent to 120 per cent between January and August.

In some instances for 2003, funds with a churn rate of slightly less than 100 per cent are included in the list because of their cash flow patterns during the first nine months -- market timing activity came to a virtual halt last September when New York Attorney-General Eliot Spitzer cracked down on the practice.

Any fund for which a churn rate exceeding 100 per cent was just the result of a major inflow or outflow of cash was eliminated from the list, because there was no pattern of similar cash flows in either direction.

The list also excludes funds exceeding the 100-per-cent threshold that had large transfers in and out in only one month. However, churn rates in these funds were included in the aggregate calculations.

And how does this compare with a benchmark? We calculated the activity in the international funds managed by TD Asset Management Inc. and Fidelity Investments Canada Ltd. Both companies, which rank among the 10 largest in Canada, have had policies and procedures in place to keep the market timers at bay. The benchmark churn rate indicates a normal level of activity.

The aggregate annual profits for the market timers were calculated by attributing all churn in excess of the benchmark standard to rapid in-and-out trading. And finally, we calculated the impact on the funds' assets by applying Mr. Zitzewitz's estimate of 60 to 70 basis points in profit pocketed by the market timers for every round trip. (A basis point is 1/100th of a percentage point.)

© 2007 The Globe and Mail. All rights reserved.

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