How Market Timing Can Constitute Fraud

Do as I say, not as I do.

Or you can do as I do, if you’re willing to make it worth my while.

That sums up the basic fraud allegations leveled against key players in the mutual fund industry during the last two months.

State and federal regulators say some fund companies in recent years have looked the other way while favored investors, or the funds’ own portfolio managers, have engaged in market-timing trades, meaning the rapid purchase and sale of fund shares.

Market timing by itself isn’t illegal. But a fund firm can be accused of fraud if it publicly tells investors that it discourages such trading, then allows certain clients to do it anyway.

The Securities and Exchange Commission and the state of Massachusetts last week charged Boston-based Putnam Investments, one of the nation’s oldest fund companies, with civil securities fraud for failing to stop some clients, and two of its own fund managers, from market timing in Putnam fund shares.

In its fund prospectuses, Putnam uses this language to describe its policy toward exchanges of fund shares, such as shifting from a stock fund to a money market fund: “The exchange privilege is not intended as a vehicle for short-term trading. Excessive exchange activity may interfere with portfolio management and have an adverse effect on all shareholders.”

Yet Putnam allowed some retirement account investors to make as many as 500 trades into and out of funds between January 2000 and September of this year, regulators said.

How does that hurt buy-and-hold investors? Rapid trading by market timers can drive up a fund’s own trading expenses, which are borne by all investors. Such trading, when profitable, also can siphon returns away from investors who stay put. Some studies have estimated that the total cost to buy-and-hold investors may be $5 billion a year.

That may be a pittance compared with the $7 trillion in total fund assets. But it’s a question of fairness and truth in advertising.

Putnam said it did not commit fraud and received no financial benefit because of the timers’ actions. The firm said that it “deeply regrets that in some instances our actions were insufficient to stop market timing by some individuals.”

One favorite sector for market timers has been funds that own foreign stocks. Timers may buy those funds late in the day when the U.S. market is rallying, betting that foreign markets will enjoy a spillover effect the next day. Fund timing in the Putnam case was centered in its foreign funds, regulators said.

Legal experts say that proving that a fund company committed fraud related to timing trades isn’t a slam-dunk. “Reasonable people could differ” about the language in a prospectus and whether it was violated, said Ron Geffner, attorney at Sadis & Goldberg in New York.

And some fund companies, he said, “may feel obligated to fight charges for reputational reasons.”