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Market timing not always profitable: CI Fund

Company review shows just 41% of trades made money

In the wake of a Report on Business special investigation, Toronto-based mutual fund company CI Fund Management Inc. says market timing is not always profitable.

The company says its own review refutes the series of articles, which found that a select group of hedge fund managers and other market professionals siphoned off hundreds of millions of dollars of value from Canadian mutual funds over a four-year period.

CI examined 405 trades exceeding $10,000 each, where clients bought shares in one of its funds one day and sold the next during 2002 and 2003. Only 41 per cent of the trades were profitable, said CI chief executive officer William Holland. "I don't believe you can make money market timing."

Other industry executives endorsed the Report on Business findings, which revealed for the first time that market timing might have been prevalent in Canadian mutual funds.

Rapid in-and-out trading in mutual funds totalled more than $220-billion between 2000 and 2003, a pattern highly suggestive of market timing, the investigation found. The activity came to a virtual halt last September, after New York State Attorney-General Eliot Spitzer launched an investigation in the United States into market timing and other questionable trading practices.

"There's a lot of money to be made at this and it's remarkably easy," said a mutual fund executive who asked not to be named.

The executive said Mr. Holland made no distinction between the small investors -- those doing the $10,000 trades -- and the hedge funds "moving $10-, $20-, $30-million overnight."

The executive also said there's a good chance the public will never find out just how much money the market pros made. The Ontario Securities Commission is doing on-site reviews of up to 15 mutual fund companies as part of its probe into market timing. But it is not looking at the hedge funds -- the starting point for Mr. Spitzer's investigation in the United States, the executive said.

Market timers take advantage of time-zone differences in international funds, where events after overseas markets close often make stock prices in the funds out of date. Not all active trading can be attributed to market timers. But the magnitude of the rapid, in-and-out trading suggests that market pros are behind much of it.

Industry executives said market timing was often done through arrangements with a mutual fund manager. A hedge fund would contact a fund manager, asking if it could "park" a certain amount of money in a fund and have a certain amount of trading activity.

"Everybody knows who it [the hedge fund] is," an executive said. "This money moves all over the Street."

In CI's survey, Mr. Holland said the company looked for investors with a pattern of jumping in and out of its funds through accounts at several brokerage firms. "They'd show up at one firm, then another and another," he said.

Market timing is not illegal. But it violates procedures many fund companies have in place to shield their shareholders from added costs and volatility.

The following example illustrates how a market timer can profit at the expense of a fund's long-term shareholders:

On Tuesday afternoon, stocks rally in New York, meaning there's a good chance markets in Japan will also rally when they reopen the next morning since overseas markets tend to track North American markets.

A market timer bets that an Asian fund is undervalued, because its portfolio of Japanese stocks does not yet reflect the market rally in New York.

At 3:45 Tuesday afternoon, the market timer puts $50-million cash into the fund by purchasing five million units at $10 each. The fund has a stock portfolio last valued at $100-million.

On Wednesday morning, markets in Japan also rally 10 per cent. As a result, the fund's stock portfolio is now valued at $110-million. However, the $50-million in cash has not contributed to this increase because it is not invested productively in stocks.

If the market timer had not jumped into the fund, it would have a net asset value (NAV) of $11 ($110-million divided by 10 million units). The $50-million cash reduces the fund's NAV to $10.67 ($160-million divided by 15 million units.)

On Wednesday morning, the market timer sells his five million units at $10.67 each, for a total of $53.35-million. His profit of $3.35-million reduces the gain for the fund's long-term investors to $6.65-million from $10-million.

Report on Business found 248 funds with a pattern of rapid, in-and-out trading, 13 per cent of all the funds examined. Nearly half were Asian or European funds.

The patterns were detected by calculating churn rates -- levels of sales, redemptions and transfers into and out of a fund as a percentage of average assets -- for hundreds of international equity funds.

The funds singled out had three characteristics: annual churn rates exceeding 100 per cent, churn that resulted mainly from money being transferred to and from funds within the same company, and monthly transfers in and out that were roughly similar.

Of the $223-billion in rapid trading over the four-year period, 88 per cent came from transfers in and out of funds managed within the same company, the investigation found.

Funds with churn rates exceeding 100 per cent were excluded where most of the activity came from either sales or redemptions.

CI had more funds than any other company on the list. Mr. Holland said several things can inflate the churn rates, including fund mergers and clones of foreign funds that are fully eligible for registered retirement savings plans.

"We merged a lot of funds," Mr. Holland said. "I just know they all factor into the grand number of our transfers."

However, Report on Business found that mergers and investments by clone funds had only a minimal impact on churn rates.

Among the five companies that disclose purchases and sales by their RRSP clone funds, including CI, these activities accounted for only 6.5 per cent of the overall $94-billion in cash that went in and out of their funds during the period.

Mergers had an even smaller impact on churn rates. Report on Business found seven funds where a merger was recorded as a transfer, for a total of $250-million.

Some fund companies, including TD Asset Management Inc. and Fidelity Investments Canada Ltd., have had procedures in place for years to make market timers unwelcome in their funds.

Others began taking steps more recently.

© 2007 The Globe and Mail. All rights reserved.

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