by Archie M. Richards, Jr., CFP^®
December 15, 2003

Excessive trading of mutual fund shares has been much in the news lately. But media descriptions of what went wrong have been incomplete. I describe them more fully.

Most of the activities have involved excessive trading of shares of mutual funds by some of their investors. This reduces the returns of all of the fund's investors. Here's why:

Brokerage commissions on the buys and the sells are paid by the entire fund.
• Buying and selling any stock usually cost the difference between the bid and ask prices (the "spread"). Let's say you acquire 100 shares of stock that costs $20.05 a share (the asked price). If you had sold the same stock at the same moment, you might have received only $20.00 a share (the bid price). The 5 cents difference pays the market maker for holding an inventory and standing ready to buy or sell the stock at any moment. With institutional trading, the spread widens, because the large amount of stock held in inventory increases the market maker's risk.

• Active trading of shares of the fund requires the fund manager to increase his holding of cash, to ensure that when fund shares are sold, payments can be made within the required three days. Cash is invested at low interest rates, not in the investments the fund purports to own. Called an "opportunity cost," it reduces the return of all investors.

Not all mutual fund organizations have engaged in wrongdoing, of course. But the illicit activities of some are as follows:

Excessive Trading by Insiders: Trading by Richard Strong is the prime example here. Mr. Strong, the founder of Strong Capital Management, acquired with his own money large blocks of the company's mutual funds. He sold the shares more quickly than he should have. Assume that the prospectus requires that investors hold shares for at least six months. Mr. Strong's sale of his shares in only a month would be a violation.

Excessive Trading Arranged by Brokers: Brokers (especially of Prudential Securities) placed large amounts of client money with over 60 mutual funds. The brokers then traded the fund shares more frequently than the prospectuses permitted. Because the mutual funds wanted the brokers to continue bringing in new money, they took no action to prevent the trading.

Late Trading: Assume that a hedge fund acquires shares of a U.S. mutual fund that specializes in Japanese stocks. Trading in U.S. funds is supposed to stop at 4:00 p.m. Eastern time. But assume that the Singapore market, which lists Japanese stocks, opens at about that time. Two hours later, at 6:00 p.m., the hedge fund observes whether Japanese stocks are up or down in Singapore. If they're up, it holds the shares of the U.S. fund and sells the next day at a profit. If the Japanese stocks are down, it sells at the 4:00 p.m. price, thereby preventing a loss. For the fund's other shareholders, this causes lower profits and higher losses. Compounding the violation, the hedge fund pays the U.S. mutual fund or the fund manager for the right to engage in the illegal activity.

Because of publicity about wrongdoings, many traders of mutual fund shares have migrated to three mutual fund groups, Rydex, ProFunds, and Potomac. These organizations are set up properly and legally for investor trading of fund shares. They offer only index funds. The funds don't acquire shares of the individual stocks; they buy and sell "derivative" investments instead. Let's say that Rydex offers a fund that tracks the S&P 500 Index. As investor money flows in or out, the fund buys or sells Spiders (an exchange-traded fund) or S&P 500 futures contracts. Both of these derivative investments track the S&P 500 Index, but they can be bought and sold easily.

Other mutual fund companies that are not set up for active trading have neglected their primary duty: to care for the interests of their customers - all of their customers.