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Industry resists rules to police trading

Firms left to adopt their own policies

Canadian securities regulators and the mutual fund industry itself have failed to introduce rules to detect and deter abusive trading practices such as market timing, leaving companies to tackle the issue on their own.

Mutual fund companies have not been able to agree on a set of industry-wide rules to clamp down on sophisticated market professionals who make quick profits by zipping in and out of their funds. As a result, policies aimed at curbing a practice that hurts long-term investors vary widely from company to company.

The Investment Funds Institute of Canada (IFIC) set up a committee in January in response to the U.S. mutual fund scandal, where widespread evidence of market timing and other questionable trading had been uncovered.

According to sources close to the committee, IFIC president Thomas Hockin urged the Canadian industry to proactively take steps to address market timing before domestic regulators imposed any new rules. But the committee could not reach an accord, revealing how difficult it is for IFIC to speak with one voice for the industry, the sources said.

Mr. Hockin was on vacation last week and unavailable for comment.

Ralf Hensel, senior counsel at IFIC, acknowledged in an interview that the committee wanted to recommend that companies impose an automatic, 2-per-cent penalty against any investor who jumps in and out of a fund within five days. But the proposal -- similar to draft rules in the United States -- was dropped following resistance from some fund companies, he said .

"To try to put a cookie-cutter solution on everybody is just not going to work, and we realize that," Mr. Hensel said in an interview. "Of course, it's a democratic process. People are permitted to agree or disagree."

One industry source said some smaller companies balked at the cost associated with implementing an automated fee while some bigger companies were satisfied with the manual procedures they have in place. "There were just too many differences in how to go about it," the source said.

IFIC plans to release a paper on market timing later this summer, but it will stop short of making specific recommendations, Mr. Hensel said. "My sense is it will end up as a principle-based document that says, 'we all agree we will not allow any activity that's harmful to our funds, and we are each pledging that our systems are adequate to deal with market timing,' " he said.

The IFIC paper will also outline three key procedures fund companies can implement to detect and deter market timing, including charging short-term trading penalties, monitoring trading and introducing a system of fair-value pricing, he said.

The paper will be the first official document in Canada that addresses market timing since a broad crackdown began in the U.S. fund industry 10 months ago. New York State Attorney-General Eliot Spitzer and the U.S. Securities and Exchange Commission have launched dozens of criminal and civil probes into the mutual fund industry over allegations of late trading and market timing, which involves rapid in-and-out trading. So far, the industry has faced more than $2-billion (U.S.) in fines and a raft of proposed new rules aimed at preventing abuses.

In Canada, by contrast, securities regulators have come under criticism from investor advocates for taking so long to conduct their own probe into market timing. The Ontario Securities Commission sent out questionnaires to every fund company in the province last October, seeking information about their policies and procedures designed to limit market timing. It is now in the process of conducting on-site reviews of about 15 companies.

A Report on Business investigation last month found tell-tale signs of market timing 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.

OSC officials are saying little, if anything, about their findings and whether they plan to implement new rules to combat trading abuses. Many fund companies are not waiting for the regulators to act.

"In general, we encourage fund companies to take pro-active steps to control trading abuses in their funds," OSC spokesman Eric Pelletier said. "However, until we complete our methodical probe and understand the root of any problem, we won't be promoting any particular solution."

A review of legal disclosure documents for several mutual funds reveals that many companies are bolstering their efforts to banish the market timers.

Clarington Funds Inc. now says in the prospectus for its funds that it will charge a short-term trading fee of 2 per cent if someone redeems their units within 30 days of purchasing them.

"We wanted to show we were serious, to make sure we told the world we had a mandatory fee so nobody could come back and say, 'I didn't know what the rules were,' " chief financial officer Salvatore Tino said.

Clarington is one of only a handful of companies that uses the word "will" rather than "may" in connection with the short-term trading fees. Many funds say in their prospectus they may charge a fee for selling within 90 days of buying units in a fund -- wording that has not changed since Mr. Spitzer put market timing on the radar screen.

Clarington and RBC Asset Management Inc. have also adopted systems to update prices of mutual funds that have international stock holdings.

Fair-value pricing, which involves using estimates to set the value of securities in a mutual fund, is considered one of the most effective tools to curb market timers who take advantage of time-zone differences in international funds.

Fidelity Investments Canada Ltd. has used fair-value pricing since the early 1990s and has been urging other companies to follow its lead. The Report on Business investigation found little signs of market timing in Fidelity's international funds. Fair-value pricing takes the profits out of market timing by removing any opportunity to arbitrage time-zone differences. Events after overseas markets close often make prices of stocks in a fund out of date. As a result, the market timer bets that the fund's units are worth more than he pays for them. The profits he pockets come at the expense of a fund's long-term investors.

Altamira Investment Services Inc. has found other ways to ward off the market timers from its international funds. Three years ago, when the company saw the potential for market timing, the prospectus for its funds said anyone who switches out of a fund within 30 days will be charged an early withdrawal fee of 2 per cent.

© 2007 The Globe and Mail. All rights reserved.

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