In re: File S7-11-04 (the "FILE") pertaining to proposed rule 22c-2 [17 CFR 270.22c-2]
To whom it may concern,
In simple terms, rule 22c-2 proposes to cure a severe class of financial market illnesses (illegal late-trading and time-zone arbitrage of mutual fund shares by hedge funds, etc.) by creating a severe penalty (mandatory 2% fee on all investors) for a condition only sometimes correlated to the illness (frequent share trading, as defined).
The Discussion section of the FILE clearly states that the major goal of rule 22c-2 is "reducing or eliminating the ability of shareholders who frequently trade their shares to profit at the expense of fellow shareholders". However, the Background text shows a woeful failure in isolating the practices that most greatly harm fund shareholders.
1.) Background paragraph 2, concerns investors who trade excessively "in reaction to market news or because of a change in heart". Such actions are completely irrelevant to the mutual fund abuses that have been in the headlines. These scandals concerned investors who were allowed to profit in reaction to market news by "late-trading", or illegally purchasing securities at prices that should have no longer been valid. Would late-trading be less illegal if the shares were held for more than five days? What if the investor paid the 2% fine, but the illegal profit opportunity was over 2% anyway? The truth is that nervous investors who trade frequently in reaction to market news or a change in heart are destined to lose over time, but in doing so they contribute to the returns of long-term investors (as such nervous investors will tend to often "buy-high" on good news and "sell low" on a change of heart, rather than for any sound business reason). Imposing a mandatory fee on these individuals (rather than focusing specifically on "late-trading" and other truly illegal practices) is nothing more than an attempt to regulate human nature.
2.) Background paragraph 3, concerns "frequent fund traders [that] seek short-term profits by buying and selling shares in anticipation of changes in market prices". To be even more redundant, we can state that nearly every participant in the market seeks to profit by buying and selling securities in anticipation of changes in market prices. While Warren Buffett buys securities in anticipation of price changes over many years, some investors may choose to focus their time and energy on shorter time frames. In a free market, investors should be allowed to do as they please, and the aggregate actions of all parties will promote the most "efficient" market conditions for all. Here, the SEC follows with a statement that "[some] have exploited pricing inefficiencies in which the price of the mutual fund does not accurately reflect the current market value of the securities held by the fund". This is a wholly separate issue from the time frame on which an investor chooses to focus. The solution to the problem of trading based on such inefficiencies is to require the funds to settle such trades based on an accurate calculation of market value, thereby removing the (illegal) arbitrage. Failure to do so is really nothing more than a material breach of the fiduciary responsibility owed to the non-selling shareholders.
The solution to these problems is to eliminate the existing pricing inefficiencies. "Late trading" is a clearly illegal practice that should be fought through strict enforcement of existing statutes. An industry-wide standard to "time-stamp" mutual fund trades would be a simple and effective way to put and end to this problem. "Time-zone arbitrage" and similar abuses should instead be eliminated by overhauling fund settlement and pricing mechanisms to remove the opportunity to profit from inaccurate portfolio pricing.
By simply eliminating these arbitrage opportunities, excessive trading based on such conditions will cease. This also puts an end to the question of allocating the increased transaction costs related to such trading. The playing field is then again leveled for firms who cater to frequent traders (Rydex, et al.) to compete with those focused on long-term investors (Vanguard, etc.) based on management fees, fund loads, share class structure, etc. If an investor then loses money because he/she made a poor investment decision, so be it.
Finally, if the SEC really feels it necessary to define a frequency of mutual fund trading by an individual that is "abusive" and merits a fee-based penalty, why doesn't the SEC define a similar abusive level of portfolio turnover and institute a mandatory fee rebate from the fund managers?
Matthew D. Kelty