Thursday, September 20, 2007

Disclaimer Day

Market-Timing Case Is Settled - Disclaimer 1 - As Good As News will always find a humorous angle, but the balance of this item is an explanation of what "market-timing" really means in this context and why the abysmal failure of the media, including the financial media, to understand this issue and call it what it is has allowed the guilty to get off lightly. This will require some concentration, skip to another post if you are here just for laughs. First, let's recap the story, but add some labels to simplify things. Evergreen Investment ("Mutual Fund"), owned by Wachovia ("Big Bank") and one of Evergreen's managers, William Ennis (Desperate to Please, or Desperate for short) have settled charges of "improper market timing" (also know as fraud) with the SEC. Isn't market timing something smart investors do legally all the time? Not this kind of market timing, that's why it's such a poor choice of words.

What actually happens in improper market timing, aka fraud? Let's use an example, simplified in some ways that do not change the principles involved. Mutual Fund is an open ended fund, meaning investors can buy and redeem shares of the fund whenever they want, with the share price recalculated every day so that the price of a share always changes in proportion to both changes in the value of the assets owned by Mutual Fund and changes in the number of shares outstanding. A new share price for Mutual Fund is calculated at 5PM, NY Time every day and orders for new shares received during the day are filled at that price. In other words, investors place their order before the exact price is determined. Now suppose Mutual Fund specializes in buying shares of European stocks. One Tuesday morning a hedge fund manager (hereinafter Mr. Piggy) wakes up and sees that every European stock index has gone through the roof. Mr. Piggy calls his friend Desperate very early in the morning on Tuesday and says sell me shares of Mutual Fund at the price you set at 5PM on Monday. Both Desperate and Piggy know the value is much higher (because the European markets have already skyrocketed but the Mutual Fund price has not been recalculated) so Piggy is asking for a bargain. Both Desperate and Piggy know it's against the rules. Desperate thinks about all the lending and brokerage business Big Bank wants to do with Piggy's hedge fund, Desperate thinks about all the lending and brokerage business Piggy could take away, Desperate thinks about the big bonus he's expecting, the one he's already spent. After struggling valiantly with this moral dilemma for nearly a millisecond, Desperate tells Piggy it's OK to buy at the Monday price early on Tuesday morning. After all, who's hurt by a little market timing, aka fraud.

Who is hurt? The other shareholders of Mutual Fund, that's who. Every dollar Piggy saves by buying after he knows the price is less than the market value comes at the expense of the other investors in Mutual Fund. When the price is recalculated at 5PM Tuesday the bargain Piggy got will be reflected in the value of Mutual Fund's assets, this dilution will reduce the price at which all the other shareholders can redeem. Because the effect of the fraudulent deal between Piggy and Desperate is spread over all the other shareholders it's not easy to spot from the outside.

In the trading world this type of "improper market timing" is called back pricing or a free option. It's fraud when a mutual fund announces one set of rules in the prospectus it gives to small investors then applies a different set of rules when it is selling shares to a favorite customer. It's highway robbery when it shifts value to the Mr. Piggies of the world at the expense of the other shareholders. Bad labels and bad explanations took the air out of a major story (there were many instances besides Wachovia) which should have produced some real outrage.

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