SEC Plan Targets Market Timing

The Securities and Exchange Commission on Wednesday took aim at abusive market-timing strategies that have figured at the center of the mutual fund scandals, proposing a 2% fee to discourage rapid-fire trading that boosts costs for other shareholders.

The mandatory charge, called a redemption fee, would be imposed on sales of mutual fund shares that investors had held for five days or less.

Commissioners voted 4 to 1 to solicit public comment on the proposal, a first step toward implementation. Even so, two Republican commissioners expressed deep reservations and Republican Chairman William H. Donaldson, a proponent, conceded that the measure raised thorny questions.

Nonetheless, Donaldson and other regulators -- facing intense political pressure to act aggressively against the fund abuses -- agreed it was necessary to move forward with the proposed reform.

“All of the commissioners have questions about the wisdom of this, the necessity for it, the fairness of it,” Donaldson said. But he also noted that the redemption fees “can be an effective deterrent to abusive short-term trades that impose unnecessary costs on long-term fund shareholders.”

Market timing is one big reason the reputation of the $7.4-trillion mutual fund industry has been shaken, and is a factor in dozens of state and federal investigations now underway.

Market timing involves holding fund shares for brief periods and then unloading them -- a practice that often is legal. But in some cases, regulators say, funds have publicly stated that they discourage or disallow market timing, but then granted the privilege to favored investors in return for huge investments.

By churning fund shares repeatedly, market timers generate significant costs for the other shareholders in a fund, typically without their knowledge.

Under the SEC proposal, the fees that investors must pay to redeem briefly held funds would go back into the funds, in effect compensating longer-term shareholders for such in-and-out transactions.

Funds would be allowed to waive the fee for sales of $10,000 or more when they are prompted by an investor’s financial emergency. They also could skip the fee for redemptions of $2,500 or less. Both provisions were prompted by fears that the proposal could harm individuals without large portfolios.

“I’ve been terribly concerned about the fairness of this to small investors,” said SEC Commissioner Harvey J. Goldschmid, noting that those provisions helped allay such concerns.

Regulators would prefer to attack market timing by ensuring that fund prices are always fair and timely, thereby taking away the opportunity for gaming. But with that goal not yet in reach, the push for a 2% “user fee” has emerged as the SEC’s most aggressive answer to abusive market timing.

Two of the commission’s three Republicans were sharply critical of the proposal Wednesday. They emphasized that market-timing abuses were addressed more effectively through accurate and timely pricing of funds, known as “fair value pricing,” which reduces the opportunities for traders to take advantage of slight inefficiencies in the pricing process.

Republican Commissioner Paul S. Atkins, who cast the lone vote against the proposal, said that even with suggested protections for small investors the proposal would cause harm. “It’s a fund tax that will hit the unwary,” he said, predicting that every year, “hundreds or thousands could get hurt by this rule through no fault of their own.”

Fellow Republican Commissioner Cynthia A. Glassman derided the proposal as “a band-aid” and said she voted to put it out for comment only in the hope of getting helpful input on ways to ensure that funds are fairly priced.

While not disputing the importance of fair and timely pricing, supporters of the fee maintained that it was a tool that would help end abusive trading and benefit investors.

“We see the redemption fee proposal as a ‘user fee’ that the fund should impose on frequent mutual fund traders, so that it can recoup the costs of the frequent redemptions,” said Paul Roye, the SEC’s director of mutual fund oversight.

Industry representatives, who have been chastised for the mutual fund scandals in a series of Capitol Hill hearings, Wednesday spoke glowingly of the measure.

The Investment Company Institute, which represents mutual funds, called the proposed redemption fee “an essential step to combat market timing abuses.”

“It is important to understand that not one cent of the redemption fee would go to managers or intermediaries,” said Matthew P. Fink, president of the Investment Company Institute.

The trade association for brokers also spoke out in favor of the approach. “We think it will be a very effective step toward ending abusive market-timing transactions,” said Marc E. Lackritz, president of the Securities Industry Assn.

Though the securities association generally opposes federal regulation of pricing, he said, “the mutual fund trading problems that have arisen are such that we support imposing an across-the-board redemption fee.”

In its fee proposal, the SEC carved out exemptions for money market funds and those funds in which market timing is a fundamental aim -- provided they disclose to investors that such practices add to costs.