that you're not playing in a rigged game:

Late trading may be more widespread than thought
By Scott Bernard Nelson, Globe Staff, 9/12/2003

Illegal after-hours trading in mutual funds, which has spawned a large and growing number of federal and state investigations over the past week, may be more widespread than previously thought and may cost shareholders $400 million a year, according to a Stanford University study.

Stanford economist Eric Zitzewitz analyzed the trading records of 104 mutual fund families, and yesterday said he had identified at least 16 with after-hours price changes "highly suggestive" of illegal trading. He did not identify individual funds or fund companies, which he said was the deal he had to make to access the data.

Zitzewitz said the practice appears to be more widespread in international mutual funds than in ones focused on US stocks. He found evidence of late trading in the international funds of 15 out of 50 fund families he analyzed, compared with domestic funds in only 12 of 96 instances.

Late traders purchase mutual fund shares after the supposed 4 p.m. close of the market, gaming the system and virtually guaranteeing themselves a profit. They typically trade based on news released after the market closes or on the direction the futures markets indicate the next day's open will take.

Some in the mutual fund world, though, expressed doubts that so many funds allow the clearly illegal practice to flourish under their noses.

"I think that to suggest that a significant part of the fund industry is either party to [late trading] or subject to it strains credulity," said Burt Greenwald, a mutual fund consultant in Philadelphia.

"Are there a few rogue people out there trying to break the laws?" Greenwald asked. "I don't think there's any question about that. But not 15 percent or 30 percent of the fund universe."

However, Zitzewitz, a visiting professor at Columbia University this academic year, said he can think of only two reasons why large numbers of trades in some fund families closely followed the Chicago Mercantile Exchange's S&P 500 futures price -- information that wouldn't have been available until after the 4 p.m. close.

"It's either got to be late trading or people are doing insider trading with mutual funds, in order to avoid detection," he said. "Just from the patterns of where the late trading was, an insider trading story just doesn't make sense."

Late trading in fund shares is one of the two practices that led New York Attorney General Eliot Spitzer to fine the Canary Capital Partners hedge fund $40 million last week, and launch a broad investigation of the mutual fund industry.

The other practice in question is market timing, or jumping in and out of international or small-cap funds, frequently in less than 24 hours, to make quick profits. The practice isn't illegal, but it violates rules most fund families have in place to shield buy-and-hold investors from added costs and volatility.

Massachusetts securities regulators launched an investigation into the Boston office of Prudential Securities last week, also, and the Securities and Exchange Commission and the National Association of Securities Dealers followed suit. The SEC also sent letters to the industry's major mutual fund firms seeking information about their policies and procedures designed to limit late trading and market timing.

Published reports yesterday indicated that Bank of America has fired two employees who were reportedly involved in deals with Canary Capital. A company spokesman last night, though, said he couldn't confirm those reports.

Yesterday was not the first time Zitzewitz's name has been connected with the growing scandal. Spitzer referred to the economist's research on market timing in court documents earlier this week.

Using trading data from TrimTabs Investment Research, the Stanford professor said his research showed that the drag created by market timers costs average shareholders in international mutual funds 1 percent to 2 percent of their assets each year. All told, Zitzewitz said, market timing costs buy-and-hold investors $5 billion extra each year.

Yesterday, he said his regression analysis indicates that late trading costs average investors only $400 million a year. Still, he said that's a significant amount of money for something that fund companies can monitor relatively easily -- as, he said, his research suggests.

"It does turn out that market timing is a much bigger deal in how much it affects the average investor, because it's more common and you're doing it off bigger market movements," Zitzewitz said. "But they're twin things, and allowing late trading is a violation of fiduciary responsibilities."

Mark Goshko, a securities lawyer at the Boston firm Kirkpatrick & Lockhart, said the past week's activity might be a wake-up call for mutual fund companies. In many cases, he said, fund companies probably didn't monitor things closely enough to realize late trading and market timing were happening.

"It is entirely possible that a fund company could have that type of activity going on and they wouldn't necessarily be complicit," Goshko said. "I can easily envision situations where brokers could have engaged in this type of activity, and in the ordinary course of business the fund company just wouldn't know."

Scott Bernard Nelson can be reached at nelson@globe.com.

© Copyright 2003 Globe Newspaper Company.