Thursday, November 29, 2012

Four winners: Can You Spot the Loser?

Four winners: Can You Spot the Loser?

A stockbroker receives the following proposition: I’d be willing to invest a large sum in one of your mutual funds and send you a slew of other stock trades if you let me trade in certain of your mutual funds and occasionally place a late day order.  The investor is particularly interested in technology-oriented, international, emerging market and small cap funds.  The broker works for a bank that sponsors a complex of mutual funds.  As you can imagine, the broker is excited because he stands to make tens of thousands of dollars in commissions.

Takeover (2007)

He takes the proposal to the management of the brokerage firm, who in turn, sets up meetings with the mutual fund distributor (another arm of the bank) and the sub-advisor (still another part of the bank that actually manages the money).  The mutual fund distributor is pretty excited about the proposal because it means higher fund balances and more fees.  The sub-advisor is lukewarm about this idea because the investor’s cash will be continually sloshing in and out of certain funds, creating pressure to quickly buy and sell securities.  This creates a lot of pressure on the portfolio managers.  However, this is a win-win-win.  The brokerage firm will make commissions and trading profits.  The distributor will earn a bunch of additional fees.  And, the sub-advisor will get more management fees.

 The investor has one additional requirement.  While his investment strategy is sure to generate profits, the individual profits are quite small.  In order to magnify the returns, the investor will require a loan from the bank.  This is no problem at all.  The bank is more than happy to earn interest and fees on the loan.  As a result, the bank is looking at the golden nugget of banking: a win-win-win-win from one client.  The investor needs just one additional small favor: a timely list of the securities in the mutual funds.

And so it begins.  The investor starts submitting all sorts of buy and sell orders for three or four of the most volatile mutual funds.  The back office, which has to process all these trades, is overwhelmed.  The portfolio managers starts stressing out because they never know when they’re going to receive a pile of cash or have to raise a pile of cash.  And, compliance has woken up to the fact that the prospectus limits the number of permissible trades in a mutual fund in a given time period.

The investor has become too important to curb this activity.  In order to make it easier for the investor to enter trades, the broker arranges for the investor to have an automatic order entry system installed in the investor’s office.  The distributor decides to grant the investor a waiver from the usual trading limits, so the compliance issue goes away.  The portfolio manager is still grumpy, but he can use derivatives to manage the cash flows.

What’s the investor’s strategy all about?  The rapid trading has several multiple purposes.  A piece of the strategy is market timing.  The mutual fund is a convenient way to quickly create and eliminate exposure to certain sectors of the market (note: exchange traded funds have supplanted this advantage). 

Another part of the strategy is to capture anomalies between the value of the mutual fund and the value of securities in the portfolio.  This works particularly well in international and emerging market funds.  While the mutual fund is priced at 4pm when US markets close, international funds trade in different time zones.  This means that there may be a built in profit or loss in the mutual fund.  For example, suppose US stocks have a huge rally and close up 2%.  It is pretty likely Europe will follow suit and rise in tomorrow’s trading.  However, the rally in Europe won’t be reflected in mutual fund prices until tomorrow.  So the investor would buy a European fund today and sell tomorrow when the European markets catch-up to the US rally and are reflected in the mutual fund’s price.  There’s some risk that the investor has mistimed the markets or that Europe doesn’t rally, but more often than not the investor will profit.

The third strategy is a sure-fire way to make money.  It’s late day trading.  The idea is to place orders after the deadline for putting in mutual fund orders.  Late orders aren’t unusual.  During the day, brokers are prone to make mistakes (e.g., buys that should have sells, or orders for 10 shares that should have been 100 shares).  What the investor had in mind is quite different and is best explained by an example.

Suppose a company held in a mutual fund announced important news after 4:00 pm, such as an earnings announcement or merger.  The company’s stock would move up or down, but would not be reflected in the mutual fund’s NAV until the following day.  The mutual fund was priced at an NAV of $10.00 and owned a 5% position in ABC Tech Company.  ABC reported a fantastic quarter, and the stock goes up 10% in after hours trading.  Thus, we have a very good idea that the NAV is going to rise to $10.05, or maybe even more as all the technology stocks in the portfolio are likely to get a boost.  However, this improvement won’t be reflected until 4:00 pm tomorrow, when the investor will sell.  With late day trading privileges, the investor can grab hold of that nickel because he’s allowed to purchase the mutual fund at $10.00.  Moreover, the gain is magnified because a hefty part of the purchase price came from the bank’s loan.

Who loses?  You can probably guess.  But we’ll leave the fallout until tomorrow.

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