What Investors Should Know About the Mutual Fund Scandal
Richard A. Weiss
Chief Investment Officer, City National Bank

By now, most investors are aware of the Securities and Exchange Commission’s probe into the mutual fund industry. The concern revolves around two issues in mutual fund trading: late trading and market timing.

Late trading is an illegal practice that allows an investor to execute transactions after the actual market close but still receive the closing price. Late trading gives an investor an unfair advantage over other investors by allowing them to trade on information that is unavailable to others. Several prominent mutual fund families have been drawn into this probe, and several investment executives at these firms have been fired or brought up on criminal charges.

The other hot issue is market timing, which is legal, but often discouraged. With market timing, investors make short-term trades in an effort to benefit from small mispricings and inefficiencies among securities or markets. It is disruptive to mutual fund providers because its short-term nature affects money flows within a fund. Maintaining enough liquidity to accommodate market timers can be a drain on performance for a mutual fund which, in turn, may be detrimental to other longer-term, buy-and-hold shareholders.

What is being done to stop these illegal and detrimental practices? First, the SEC and other regulatory bodies are taking this very seriously. As already mentioned, criminal penalties are being given to those involved with late trading. And there is a proposal to charge extra fees for short-term market timing, effectively making it an unprofitable activity for investors.

Many investors who are holding shares in fund families that are under investigation are wondering what action they should take. City National Bank recommends consulting with a financial professional for a couple of reasons:

• Depending on the specific situation, there may be tax or other considerations that would discourage an outright sale of shares.
• It is not clear that all of the funds that engage in late trading have been uncovered at this point, so if an investor sells out of an implicated fund, and reinvests, he or she may be jumping out of the proverbial frying pan into the fire.

Late trading or market timing is not necessarily a blanket reason to sell today. However, if investors continue to sell holdings in those funds under investigation, the outflows may not bode well for competitive future returns, at least in the short-term.

This article is for information and education purposes only and does not constitute a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. Clients should evaluate the merits and risks associated with relying on any information provided.