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In-and-out traders unwelcome, firms say

Taking steps to shore up confidence

The scandal sweeping through the U.S. mutual fund industry is prompting many Canadian companies to take steps to shore up investor confidence before it also becomes badly shaken in this country.

Specifically, companies are taking a hard look at how to make market timers unwelcome in their funds. "We do think there are measures the industry as a whole can adopt to dramatically reduce the inappropriate short-term trading opportunities," said Sian Brown, senior-vice president and general counsel at Mackenzie Financial Corp. "We think an industry-wide response to this issue is crucial."

Executives at many mutual fund companies interviewed for this series said they already use manual and electronic surveillance tools to detect hedge fund managers and other market professionals who are jumping in and out of their funds.

Many companies deter rapid trading by charging short-term trading fees ranging from 1 to 2 per cent. They also put the names of those caught market timing on a watch list so they don't try it again.

Jonathan Hartman, vice-president of business development at RBC Asset Management Inc., Canada's largest mutual fund manager, described industry practices as an evolution, with companies examining ways to improve their monitoring procedures. RBC, for instance, is looking at imposing a short-term trading fee.

Since at least 2000, RBC has frozen the accounts of market timers, Mr. Hartman said. At that point, the only thing the client can do is pull out his money.

William Holland, chief executive officer of CI Fund Management Inc., said fund managers are no longer allowing any client to trade in and out in under 30 days.

"The public perception right now is that this is negative," he said.

David Goodman, president of Dynamic Mutual Funds Ltd., said the firm charges a 2-per-cent fee to make it known that it wants to do business only with long-term investors. But he declined to disclose what other measures the firm has taken to deter market timers.

"I think it's better for them not to know what exactly they have to do to get around the procedures," he said.

A Report on Business investigation found that fund companies have had mixed results keeping market timers out of their funds. Rapid, in-and-out trading took place in dozens of international funds managed by Canadian companies over a four-year period.

Some companies, including CI, had funds that showed telltale signs of market timing in all four years between 2000 and 2003, the investigation found. Other companies, including Dynamic, CIBC Asset Management Inc. and AIM Funds Management Inc., had several funds in 2000 and 2001 that fit the pattern but exhibited little or no such activity in later years.

Then there were other companies, including TD Asset Management Inc., Phillips Hager & North Investment Management Ltd. and Fidelity Investments Canada Ltd., that had no sign of market timers in their funds over the four-year period.

Fidelity is the only company in Canada that has for several years used a system of fair-value pricing that updates out-of-date stock prices. Fidelity's Boston-based parent, North America's largest fund company, adopted fair-value pricing back in the early 1990s for its global operations, including Canada.

Fair-value pricing attempts to factor in changes in the value of a fund's holdings by adjusting them to reflect events that happen after the markets close. When markets are volatile or major events occur, prices of some securities might be unreliable or out of date.

Back on April 18, 2001, for example, when the U.S. markets jumped significantly following a surprise, 50-basis-point cut in interest rates, Fidelity adjusted the prices of its overseas securities.

Peter Bowen, a vice-president and chief compliance officer at Fidelity, said closing the window on market timers protects long-term investors from speculators buying in at an artificially low price and then selling at a profit the next day, a practice he likens to betting on a horse race after the event.

"No investor should have an unfair advantage over anyone else," Mr. Bowen said. "Everyone should be able to buy and sell units of the fund at a fair price."

Funds that invest in overseas markets are particularly vulnerable to market timers. By the time prices are set in these international funds, overseas markets have been closed for as many as 14 hours, and events elsewhere around the globe can make their closing prices obsolete.

The market timers attempt to exploit these price discrepancies. They can capture a share of the profits that would otherwise have belonged to its longer-term investors, whose money actually financed the investments that produced the profits. In addition to fair-value pricing, Fidelity monitors trading in its funds and imposes penalties on in-and-out traders.

While there is no guarantee that any of these steps will prevent market timers from slipping through the cracks, there is little sign of them in international funds managed by Fidelity.

In 2003, international funds where rapid, in-and-out trading took place had an aggregate churn rate of 221 per cent. The churn rate is a measure of sales, redemptions and transfers relative to average assets. By comparison, international funds managed by Fidelity had an aggregate churn rate of only 44 per cent last year.

Fair-value pricing has received added attention following investigations in the U.S. fund industry.

"Many companies are now considering it," said John Murray, research director at the Investment Funds Institute of Canada.

In the past, companies have resisted fair-value pricing for two reasons: they were worried about departing from the objective standard of using closing stock prices to value their funds, and the systems were expensive to develop.

Mr. Murray said there are now third-party suppliers that can do fair-value pricing.

Clarington Funds Inc. recently hired one of these suppliers, ITG Inc. of New York, to adjust, when necessary, the values of foreign securities in its funds.

Clarington chairman Terry Stone said the company isn't using fair valuing because of a problem with market timers in its funds. Four of its international funds had rapid, in-and-out trading between 2000 and 2003, the Report on Business found. Rather, he said, the decision has more to do with the scandal in the U.S. fund industry.

"We think that there's a cloud that's probably floated up here because of all the publicity down there," he said.

© 2007 The Globe and Mail. All rights reserved.

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