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OSC strike against fund industry just first volley in wider crackdown

Commission may target another 20 companies as part of its biggest-ever investigation

With files from reporter Keith Damsell

The Ontario Securities Commission signalled yesterday that its first strike against the mutual fund industry is just the beginning, and that it could target as many as 20 more fund companies for in-depth reviews as part of the most extensive probe in its history.

OSC enforcement director Michael Watson said in an interview yesterday the regulator will target those companies where it is most likely to find evidence of rapid, in and out trading in their funds, activity characteristic of market timing.

Yesterday, the commission announced that it has put four companies on notice that they could face enforcement proceedings as part of its probe. Investors Group Inc., CI Fund Management Inc., AGF Funds Inc. and AIC Ltd. have 10 days to explain alleged market-timing violations in their funds.

The commission did not level specific allegations of wrongdoing against the companies and also noted that its staff has not uncovered any evidence of late trading, a practice that is clearly illegal. But the bad news is far from over for Canada's $468-billion fund industry.

The companies targeted by the commission, and indeed the regulator itself, sought yesterday to portray market timing as yesterday's problem.

"We are a creature of public perception in a lot of ways," said CI chief executive officer William Holland. "The minute it became a public issue, you're foolish not to make changes."

Market timing involves the rapid, in and out trading in a fund by hedge funds and other market professionals. The practice all but disappeared on Bay Street last September, the same month U.S. regulators launched a broad crackdown into abusive trading.

But while it flourished, market timing enriched sophisticated market professionals at the expense of ordinary investors in a fund.

Rapid, in-and-out trading in mutual funds totalled more than $220-billion between 2000 and 2003, a pattern highly suggestive of market timing, according to a Report on Business investigation published in June. The activity came to a halt last September, the investigation found.

The pros typically favoured overseas funds, where time zone differences often make prices of stocks in a fund out of date because of market events elsewhere. While the practice is not illegal, it violates procedures many fund companies have in place to shield their shareholders from added costs and volatility.

The commission is only part way through its probe into potential trading abuses. To date, it has conducted on-site reviews at seven fund companies and could examine up to another 20, Mr. Watson said. As well, self-regulatory agencies for the brokerage industry and mutual fund dealers have launched a number of investigations.

"We keep on getting further evidence as the probe continues," Mr. Watson said. "It changes and often expands our focus."

In the United States, securities regulators have launched dozens of criminal and civil probes.

New York State Attorney-General Eliot Spitzer was the main investigator into the mutual fund industry over allegations of late trading and market timing. So far, the regulators have reached settlements totalling nearly $3-billion (U.S.) with a dozen fund companies and introduced a raft of proposed rules aimed at preventing abuses.

It is not clear at this point what action regulators on this side of the border might take against fund companies. At least one company, AGF, said it will attempt to persuade the regulator that no enforcement action against it is necessary.

Mr. Watson said the regulator can only impose fines against a company accused of wrongdoing that enters into a settlement agreement. However, he said, the OSC now has the power to force someone to repay ill-gotten gains.

While market timing is not illegal, a fund manager can violate his duties to long-term investors by allowing market timers to jump in and out, he said.

"If a small handful of investors are being allowed to rapid trade through a fund, that has significant financial impact on the longer-term investors who are simply holding while this activity is going on," Mr. Watson said.

The commission said it sent notices late Monday to the four companies concerning "alleged market-timing violations only." It put the onus on the companies to identify themselves.

The Report on Business investigation found tell-tale signs of market timing in dozens of Canadian mutual funds, including those managed by Investors Group, the country's second-largest fund manager, CI, the fourth largest, AGF, No. 8, and 13th-ranked AIC.

The alleged market-timing violations the OSC is examining span several years. In the case of AIC, the company said the OSC identified concerns with frequent trading activity that occurred from January, 1999 to October, 2003 -- the longest period for any of the four firms.

All four companies said they now have procedures in place to keep the market timers at bay, including short-term fees to deter the practice.

OSC chairman David Brown addressed criticism yesterday that the regulator has not moved swiftly enough to get to the bottom of any trading abuses in Canada's fund industry.

He said the OSC probe involves staff from three branches -- investment funds, capital markets and enforcement -- who have collected an enormous amount of data from fund companies and examined millions of trades and thousands of accounts.

"In our view, the probe has proceeded quickly," he said. "It's been a very thorough review and is probably the most extensive investigation we've ever undertaken at the OSC."

Looking behind the churn rates

A Report on Business investigation published in June found a strong indication of market timing when it examined transfers in and out of funds. Transfers account for the lion's share of activity in those funds with churn rates exceeding 100 per cent. By contrast, funds used as a benchmark comparison saw more evenly spread activity. Fidelity investments Canada and TD Asset Management were chosen for the benchmark because each company has for several years had procedures in place to dissuade market timers.

The yearly breakdown for funds with churn rates exceeding 100 per cent.

.................Sales...Redemptions...Transfers In...Transfers Out...Churn

2000...........30.8%.....13.9%..........116.4%..........112.6%.....273.0%

Benchmark...25.0.......11.7...............13.1.............12.7.........62.5

2001...........17.5.......18.2..............102.7............107.4........245.5

Benchmark...14.9......14.3.................6.1...............8.7.........44.2

2002.............7.9......14.0...............162.5............166.3.......352.0

Benchmark....13.1......15.5.................4.0...............8.3.........40.9

2003.............12.1......19.4................93.1.............96.6.......221.2

Benchmark....11.0......16.7.................8.4...............8.5.........44.5

In-and-out trading

The pace of in-and-out trading rose steadily through to 2002, when 73 funds had churn rates exceeding 100 per cent. A churn rate of 100 per cent means that cash equal to a fund's average assets changed hands during the course of a year.

........Number of fund

...companies with in-and-out

......trading in their funds............Number of funds

2000.............13..............................43

2001.............16...............................79

2002.............16..............................73

2003.............15..............................53

High stakes

The dollar value of rapid in-and-out trading peaked in 2002, falling off after September, 2003, when U.S. authorities launched a crackdown on market timing and other questionable practices.

$billion

2000....44.2

2001....62.7

2002....89.8

2003....25.5

© 2007 The Globe and Mail. All rights reserved.

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