February 2, 2004

Jonathan G. Katz, Secretary
Securities & Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

Re: Proposed Rule: Amendments to Rules Governing Pricing of Mutual Fund Shares - File No. S7-27-03

Dear Mr. Katz:

I am writing in response to the Commission's request for comment on issues relating to the proposed rule on amendments to rules governing pricing of mutual fund shares. I am pleased the Commission is soliciting public comment on the issues that may be raised by these proposals as I believe there are significant shortcomings in the proposed rule, and the Commission should take the opportunity to modify the proposal before making the rule changes effective.

My comments address what I believe to be the significant problems with current pricing practices and the proposals.

Protecting Fund Shareholders from Fund Share Trading


Early in September 2003, Eliot Spitzer, New York State's Attorney General, announced a $40 million settlement with a hedge fund that had allegedly engaged in "late trading" and "market timing" with mutual funds. In what Spitzer and the media defined as "late trading," the hedge fund had been permitted to buy and sell fund shares at the fund's 4:00 p.m. net asset value (NAV) several hours after the prices used in the NAV calculation were determined, a violation of Securities and Exchange Commission Regulation 22c-1. Distinct from the transactions at "backward" prices were a number of "market timing" trades initiated at or slightly before 4:00 p.m. In some cases, these market-timing trades may have taken advantage of "stale" prices in foreign or illiquid markets. In many cases, the market-timing trades created a need for the fund to trade during the following day's trading session. Any market impact cost of the next-day trades was borne by all the fund's shareholders.

I expect further investigation to confirm that illegal backward pricing of fund share transactions - "late trading" - is rare.1Unfortunately, there is strong evidence apart from the recent publicity that fund share orders coming to a fund late in the day are common. These orders come from investors with motives far more diverse than "market timing" the fund over a few days.

Since the Spitzer settlement called attention to these practices, the emphasis of most regulators and pundits has been on preventing clearly improper trades based on stale prices or executed in violation of prospectus language that states a policy against in-and-out market timing trades. Stopping these abuses is important, but the abuses cited are possible only because the industry standard mutual fund pricing and trading process is inherently flawed. Investor outrage offers an opportunity to make changes that will fix more costly problems than the scandal itself has uncovered. The simple fact is that most fund share trades that arrive late in the day are costly to existing fund shareholders, whether they were initiated by short-term traders or by ordinary investors. My purpose is to contribute to understanding of (1) how costly the current fund share trading process is to shareholders in mutual funds and (2) why all transactions received after 2:30 p.m. should be priced at the next day's 4:00 p.m. net asset value.

Published estimates of the effect of fund orders entered at or just before the market close range upward from trivial levels to $5 billion per year.2These are generally estimates of the profits earned by market timing traders. In contrast, my estimates recognize that orders the fund does not receive by early afternoon cost fund shareholders much more than just the profits that some traders take away.3I estimate that the fund shareholder performance penalty from late-afternoon trading approaches $40 billion per year.

Non-Timer Trades May be As Costly As the Most Aggressive Market Timing

Last-minute fund buy orders frequently arrive on days when the market is strong near the close. It is impossible for a trader to buy the stock positions held by a typical equity fund at 4:00 p.m. prices by entering stock buy orders at 3:59 p.m. The trader can, however, buy shares in most funds a few seconds before 4:00 p.m. Just as it is impossible for a trader to execute stock trades right before the net asset value calculation, it is impossible for the fund to make a trade for its portfolio to invest the new cash. Whether they intend to get in and out quickly or to stay for years, many fund share buyers make last-minute purchases on days with a strong market at the close. If they capture market momentum, their trades are particularly costly to their fellow fund shareholders. The fund will have to buy stocks at even higher prices on the next trading day to invest the cash inflow. Correspondingly, if a shareholder redeems fund shares with an order entered near 4:00 p.m., the fund will have to sell portfolio securities the next trading day, often at lower prices, to cover the redemption. The fund is providing free liquidity for these investors and the fund's shareholders pay the cost of that liquidity. Fund trades to capture momentum at the market close appear to be the only way momentum traders can profit from their strategies because they can transfer the high trading cost of momentum strategies to fund shareholders.4

The Cost of Providing Free Liquidity to Mutual Fund Share Traders

Studies of the impact of fund share trading offer compelling evidence that the costs to ongoing (non-trading) shareholders are substantial. In a study to measure the cost of providing liquidity to entering and leaving shareholders, Roger M. Edelen (1999), then a Wharton School (University of Pennsylvania) professor, quantified the adverse effect of shareholder entry and exit costs on fund performance.

Using a sample of 166 conventional (no load) funds ranging in type from "small cap" to "income," Edelen investigated the cost to the fund of providing liquidity to investors who enter and leave the fund.5His study examined all purchases and sales of securities by the funds over a series of six-month periods. The six-month interval was determined by the traditional portfolio reporting interval for mutual funds.6Edelen was able to break down each fund's trading into flow and non-flow components and to measure how much of the flow-related trading was incremental trading from having to purchase and sell portfolio securities in response to the entry and exit of shareholders. His methodology revealed the cost of the trading, not the motives of buying and selling fund shareholders.

Edelen did not attribute a fund performance cost to trading flow if the manager was able to use the flow to make desired portfolio changes. He concluded that for the average fund in his sample, 30% of the flow in and out of the fund did not result in incremental trading, and that about half of the fund's total trading was flow-related. If 70% of flow results in incremental trading, then about 35% of the total fund trading was incremental trading from providing liquidity to entering and leaving shareholders. The average fund Edelen studied was clearly not used aggressively by fund traders. Aggressive trade timing can easily cause a rate of annual portfolio turnover of several hundred percent.7The modest fund share turnover in Edelen's sample notwithstanding, the trading costs he attributed to the liquidity offered to entering and exiting shareholders accounted for an average net reduction in annual investor return of about 1.43%, not materially less than the average mutual fund's expense ratio.89

The 1.43% cost of providing liquidity to buyers and sellers of fund shares is the source of our $40 billion estimated performance cost of late-afternoon fund share orders. The calculation is simple. The latest available figures show assets in U.S. stock and hybrid funds at slightly less than $3.9 trillion. Applying a cost of providing liquidity of just over 1% gets us easily to a $40 billion estimate without stretching the possibility for improvement. In fact, a small number of intensely shareholder-protective funds succeed in eliminating the impact of these trading costs and may even earn a small profit for the fund on share turnover. The protective funds do this simply by cutting off fund share buy and sell orders early in the afternoon and by trading for the fund before the market close so that the cost of portfolio trading is reflected in the net asset value calculation that prices the shares for entering and leaving shareholders. If all funds had these protective policies, fund investors' returns might improve by more than $40 billion per year.

A Possible Solution

A possible solution to the free liquidity problem is based on three changes:

    (1) For domestic equity or balanced funds, any open10mutual fund would accept purchase orders and all redeemable funds would accept redemption orders delivered to the advisor until 2:30 p.m. on any normal11business day for pricing at that day's net asset value. No order cancellations would be permitted after 2:30 p.m. and the fund could trade to adjust its portfolio for these investor orders before the market close.

    (2) After 2:30 p.m., market makers unaffiliated with the fund advisor would be able to provide liquidity to investors who want to enter an order for execution at a share price based on that day's net asset value.

    (3) For funds holding more than 3% of their assets in stocks traded on one or more primary markets outside the United States, orders would be accepted until 4:00 p.m. on any U.S. business day for pricing at the net asset value next determined for the fund after a full trading day in the primary markets for stocks accounting for 97% of the fund's equity portfolio.

I elaborate on these proposals below and discuss accommodating investors with special needs and fund exchange practices that are not fully consistent with this simplified statement. 12

Other Proposals to Cure Mutual Fund Problems

The SEC and others have proposed a variety of compliance rules, disclosure requirements and changes in fund operating and marketing policies. I will refer to such proposals when appropriate, but I spend little time on proposals directed at abuse detection and rule enforcement. I regard such changes as inevitable and, on balance, useful. However, my emphasis and the emphasis of some other observers is on creating a framework which removes much of the incentive and opportunity to abuse fund shareholders. Most of the proposals I discuss at length share my "framework" orientation. The proposed framework will make the other reforms more effective.

The Order Cut-Off Time

The early order cut-off suggestion has not been on most of the widely publicized lists of proposed cures for mutual fund problems. Not surprisingly, a 2:30 p.m. cut-off time is on the list of John Bogle, the founder of Vanguard. The early cut-off approach sees the problem not as market timing, but as a flawed fund share purchase, sale and pricing mechanism that invites abuse of ongoing shareholders. The early cut-off proposal stresses the impracticality of receiving orders to buy and sell fund shares, pricing the shares and trading to balance the portfolio instantaneously and simultaneously at 4:00 p.m. It cannot be done. The 4:00 p.m. cut-off endorsed by the Investment Company Institute and the Securities and Exchange Commission would continue to give free liquidity to the fund share trader. This liquidity is very costly in the aggregate to the ongoing fund shareholders who provide it.

Redemption Fees

Advocates with perspectives as diverse as John Bogle and the Investment Company Institute have endorsed redemption fees to discourage short-term traders.13Such fees are collected by a number of funds in an attempt to compensate ongoing shareholders for the fund's costs of providing liquidity to traders. These fees are, at best, a crude approximation of the liquidity cost traders impose on a fund's ongoing shareholders. The fees usually apply only to round-trip trades completed within a short period. Zitzewitz (2003b) provides examples where market timing trades can be attractive to a trader even after a 2% fee, casting doubt on the deterrent value of redemption fees. There is little support for a redemption fee higher than 2% or for a cut-off date more than 90 days after purchase. If the fund share trader avoids the redemption fee by staying past the redemption fee cutoff date, the cost of the fund's portfolio trading to accommodate the fund share trade becomes a permanent cost to other shareholders. Redemption fees probably do little harm, but they do not solve the liquidity cost problem for most fund share transactions.

Fair Value Pricing

In calculating its current net asset value, a fund is generally required to price its portfolio securities using readily available market quotations. If market quotations are not readily available for a particular security or group of securities, the fund is encouraged to value securities at their fair value, as determined in good faith by or under the direction of the fund's board of directors. A fund must consider but is not necessarily required to adopt fair value pricing of portfolio securities traded on a foreign exchange.

On a number of occasions, most famously in October of 1997, speculators purchased shares in open-end funds holding extensive positions in foreign securities. The speculators were dismayed to find that the funds had used fair value pricing, depriving the traders of what they thought was their rightful opportunity to benefit at the expense of fund shareholders. In fact, the funds were simply meeting their pricing obligation effectively.

Today fair value pricing is less controversial, although, as John Bogle points out, it has a weakness: "The difficulty with fair pricing always was and is that you can't always assume good intentions," (Strauss (2003)). Fair value pricing is essential for certain illiquid or infrequently traded positions, but it is not essential for most foreign stock funds. If we assume good intentions or if a fund holding foreign securities uses a third-party regression model (see Ciampi and Zitzewitz (2003), Zitzewitz (2003a) or Madhavan (2003)) to make a low-cost fair value calculation, pricing foreign stock funds will be relatively simple. I do not pound the table arguing that my proposal to defer pricing of foreign stock fund share transactions until the foreign market has traded for a day is superior to an objective fair value pricing alternative. I do observe that the early cut-off approach uses deferred actual prices from the foreign market, not projected prices.

Rejecting Orders From Market Timers

Many fund advisors state with varying degrees of pride, determination and conviction that they have policies to limit fund trading frequency. Some claim to have effective monitoring to reduce fund share turnover linked to short-term trading. Such policies will be more deeply embedded in prospectus language and monitored by a new independent compliance group under recent proposals from the SEC.

Last-minute purchases and redemptions are an issue because a fund is required to accept orders until 4:00 p.m. under SEC rule 22c-1 unless it has prospectus language that permits an earlier cut-off of certain types of orders. Prospectus language may permit the fund to reject or defer pricing of orders that will have an adverse effect on the fund. In practice, it is difficult and relatively uncommon for even the most conscientious fund advisors to reject such orders - at least until a clear "market timing" trading pattern is established. Most funds consider accepting orders until just before the market close to be part of their commitment to investor service. If an order turns out to be from a market timer, the fund may refuse future orders, but funds rarely reject the first order anyone enters at 3:59 p.m. And, of course, a market timer who is turned away may come back under a new identity on another day. In the final analysis, as long as the firm cut-off for fund purchases and sales is 4:00 p.m., most rules will do little more than divert timing transactions to fund groups with less stringent control of trading turnover and transaction timing. Policies against timing will not protect fund shareholders from the cost of trades by investors who are not classified and excluded as market timers.

The Motivation of Advisors in Accepting or Rejecting Orders

Clearly, many fund families have not discouraged traders - notwithstanding statements in their prospectuses. Some observers argue that fees earned on additional assets are a strong incentive to accept last-minute orders. Zitzewitz (2003a) estimates the present value of future fees at $0.20 per $1.00 of reduced shareholder dilution. If we accept this valuation, timers clearly have an adverse effect on long-term growth in assets and management fees because their trading dilutes performance. The problem with this analysis is that the manager cannot be sure which trades create nothing but dilution and which trades bring in "permanent" assets. Even new permanent assets dilute prior investors. Indeed, most things the fund manager does to bring in new assets create a conflict with the interests of existing holders with a 4:00 p.m. order cut-off.

An associate and I made calls to a number of mutual fund companies' 800 numbers before the scandal broke and we found most of them eager to accept trades in their funds until 3:59 p.m. each trading day. 14 The recently disclosed behavior of some fund advisors in facilitating late trading and market timing trades - in contradiction to their prospectus language - suggests that the conclusions some management companies or their employees have reached is that permitting market timing trades can be in their personal best interest. The fact that some of the recently disclosed decisions were made below the top management level also reveals conflicting objectives. The conclusion is inescapable that only a market framework that makes perfidy extremely difficult will prevent future trading abuses. More importantly, correctly identifying the motivation behind each transaction and rejecting timing orders will not eliminate the performance penalty inherent with a 4:00 p.m. order cutoff.

Zitzewitz (2003a) clearly describes and admirably evaluates most of the proposals and combinations of proposals that have been made to protect shareholders from stale prices and late arriving orders. The argument that the only way to achieve fairness is mandatory industry standard order cutoff times earlier than 4:00 p.m. is a solution that Zitzewitz (2003a) did not consider. He viewed the problem more narrowly than now seems appropriate. He asserted that, "So long as inflows and outflows are roughly balanced and not opportunistically timed, mutual funds can match buy and sell orders internally and provide zero-transaction-cost liquidity without significantly altering their holdings or trading themselves." As he recognizes, these conditions are often not met. Edelen's data indicates that approximately 70% of flow trading is a net mismatch. As a consequence of this mismatch, any solution that does not involve a cut-off well before 4:00 p.m. for domestic funds and effective changes for foreign funds will leave mutual fund shareholders vulnerable to abuse.

Some Funds Succeed in Protecting Their Shareholders From Dilution

Concern for the performance impact of late-arriving cash purchases and sales of fund shares prompted me to look at funds not seriously affected by this issue:

    (1) Exchange-traded funds (ETFs) that create and redeem fund shares by the in-kind exchange of portfolio securities for fund shares and

    (2) Conventional funds that effectively cut off cash purchases and sales earlier in the day.

Exchange-Traded Funds (ETFs)

Each ETF shareholder pays his or her own fund entry and exit costs either as part of the in-kind fund share creation and redemption process or simply by paying a market-determined price to buy or sell ETF shares in an open market trade with another shareholder or a market maker. The creation and redemption baskets the fund accepts or delivers in exchange for fund shares are typically identical in composition to the fund. In-kind exchanges eliminate the fair value pricing issue even for funds holding non-U.S. stocks because in-kind contributions or redemption proceeds are priced using the same securities prices used to calculate the fund's net asset value. Once an ETF shareholder enters the fund, there are no meaningful further entry or exit costs penalizing the ETF shareholder's performance until that shareholder sells his own shares. The stock market provides liquidity to the ETF share trader and the trader pays for that liquidity. The significance of this difference between ETFs and conventional funds is that other things equal, an ETF should outperform a comparable conventional fund that accepts orders until 4:00 p.m. The expected magnitude of the outperformance will be the conventional fund's cost of providing liquidity to entering and leaving shareholders.

An ETF does not have to worry about a timing mismatch with orders received at or near the market close. ETFs do, however, face a special problem of their own with late in-kind purchases and sales if the ETF is making changes in its portfolio composition without revealing the portfolio changes in advance. When creations or redemptions are made using baskets that match the "old" portfolio, a basket will change the end-of-day composition of the portfolio partly back in the direction of the old portfolio in the case of a creation or exaggerate the composition change in the case of a redemption. If the creation and redemption baskets for the next day are changed to reflect the new portfolio composition objective, the portfolio manager usually can get to the desired portfolio composition with a small trade. The fund may have to buy additional amounts or resell some of the securities added the first day or sell more or repurchase some of the securities sold to get to the desired portfolio mix. In contrast to the net 1.43% estimated cost of providing liquidity from Edelen's work, I estimate that the cost of these adjustment trades will range from a few basis points for a large-cap index fund to perhaps 10 basis points for an actively-managed ETF with daily portfolio disclosure.15Unfortunately, this feature of ETFs also appears to inhibit appropriate portfolio modification behavior by index ETF portfolio managers, further weakening their shareholders' performance.16

The solution is simply to require earlier commitment to creations and redemptions. The portfolio manager should know if she will be faced with creations and/or redemptions by 2:30 p.m. Enough transactions can be held until late afternoon to assure that the final trades will get the portfolio to the composition the portfolio manager is seeking in advance of the NAV determination.

Conventional Funds that Restrict Late Arriving Orders

Some mutual funds avoid late-day cash purchases and sales of fund shares almost entirely - by simply blocking most late orders. A number of fund groups use this approach, but the most prominent, vocal and transparent example is Vanguard. Vanguard protects its index fund shareholders from fund share trading costs by a process that, in effect, gives Vanguard early notice of cash purchases and sales of fund shares. This information lets the manager enter orders to buy or sell portfolio securities before the market close, accommodating fund share purchases and sales at little - or even negative - cost.

Vanguard's shareholder protection system is intriguing. To appreciate it, we need to understand that large investors can enter an order to buy or sell a stock at the market close or better for no net commission, as long as the broker has some time to try to make the trade at a better price than the close. An institution using market-on-close-or-better orders will trade at no apparent cost. If the broker does better than the closing price used in the NAV calculation, the fund may share the benefit of the better price and earn a small profit relative to the close.17To give brokers time to work these orders before the close, a fund needs to know its net cash flow by early afternoon. To this end, Vanguard will not accept an inter-fund transfer instruction after 2:30 p.m. on any trading day. For example, an investor cannot initiate the same day transfer of assets from a Vanguard money market fund to a Vanguard equity index fund (or vice versa) after 2:30 p.m. Vanguard theoretically accepts wire purchase instructions until 4:00 p.m., but reserves "the right to reject any purchase request that may disrupt a fund's operation or performance."18 Vanguard does not accept wire redemption orders. They nominally accept mail orders until the market close, but mail orders go to post office boxes and there is obviously a time when they stop collecting and opening mail for the day. Vanguard apparently follows industry practice in giving 401(k) plan investors the closing price on the day an order is entered even if Vanguard does not receive notice of the order until the following day. The aggregate daily value of trades in these accounts is often predictable, but Vanguard retains the right to restrict any short-term trading efforts or defer the pricing of large orders.

Vanguard's approach to ongoing shareholder protection by restricting last-minute trades is probably slightly better than the ETF shareholder protection process, even with the early notice requirement we suggest for ETFs. A Vanguard index fund is more likely to "profit" very modestly from a larger number of market-on-close or better trades by the fund manager.19

It is useful to view the fund share trading process in terms of price discovery. The hedging transactions of market makers and same-day portfolio transactions by a conventional fund to equitize fund share purchases and sales contribute to stock price discovery. Fund share orders that a fund cannot translate into portfolio trades before the market close do not contribute to price discovery. If fund share orders are priced at an NAV that is unaffected by the change in fund asset levels which the orders represent, the process distorts closing stock prices and increases probable shareholder dilution.

Fund shareholders would benefit from something like the "Vanguard process" or from entry and exit exclusively through an ETF share class. Alternatively, the Commission could simply require all open-end domestic equity funds to cut-off orders at 2:30 p.m. The ETF and Vanguard examples suggest that this may be a "universal solution" to fund shareholder dilution.

Why Have Market Forces Not Solved the Problem?

There are basically two reasons why market forces have not solved the free liquidity problem. The first of these is illustrated by the competition among fund advisors to make buying and, of necessity, redeeming their fund shares as convenient as possible. While there is an incentive to provide the best possible treatment of ongoing shareholders, it has been distorted by pressure to attract new shareholders. However, the regulatory framework for purchase, sale and evaluation of mutual fund shares is at least as great an obstacle to shareholder protection as the conflicts fund managers face.

To understand fully why fund share trading problems occur and why making an effective change is difficult, we need to examine Securities and Exchange Commission Rule 22c-1. This rule, which requires forward pricing of fund share purchase and sale transactions, is also the principal obstacle to implementation of an early trade cut-off requirement. The key provision of Rule 22c-1 is in its paragraph (a): "No registered investment company issuing any redeemable security, no person designated in such issuer's prospectus as authorized to consummate transactions in any such security, and no principal underwriter of, or dealer in, any such security shall sell, redeem, or repurchase any such security except at a price based on the current net asset value of such security which is next computed after receipt of a tender of such security for redemption or of an order to purchase or sell such security" (italics added).20All ETFs have exemptions from this rule to permit their shares to trade at market prices in the secondary market - but that is the extent of their exemption. Some conventional funds (e.g., Vanguard) have received permission to adopt prospectus language and policies for shareholder protection that let them reject or delay pricing on some late-arriving orders. Most recently, the Investment Company Institute obtained a no-action letter (Securities and Exchange Commission (2002b)) that permits deferred pricing of exchanges among funds in the same "family".

The SEC's published statements at the time Rule 22c-1 was implemented and subsequent statements by SEC Commissioners and Staff make clear that the most important purpose of Rule 22c-1 was to reduce dilution of the holdings of ongoing shareholders when a fund sells shares to or redeems shares from entering and exiting fund shareholders. 21The dilution the Commission sought to prevent came about principally because, prior to the implementation of Rule 22c-1, some investors were permitted to purchase shares of a fund in a rising market at a stale price that was lower than the fund's current value or than the net asset value would be when next calculated. An investor might also have been able to redeem shares during a falling market at a previously set price that was higher than the fund's net asset value would be when next calculated. In either case, the interests of the ongoing shareholders of the fund were being diluted by this opportunity for entering or departing shareholders to obtain better prices than they would be entitled to if forward pricing, the principal requirement of Rule 22c-1, was in place. Until the implementation of Rule 22c-1 in 1968, backward pricing ("late trading") - the most serious offense alleged in the recent Spitzer settlement - was legal.

There is no question that the forward pricing principle of Rule 22c-1 is critical to fairness and to the perception of fairness in mutual fund pricing. The fairness of forward pricing has clearly been an essential element in the increased popularity mutual funds have enjoyed since Rule 22c-1 was adopted by the Commission.

The problem with Rule 22c-1 is that both conventional funds and ETFs are largely bound by the provision that they cannot, "sell, redeem or repurchase [their shares] except at a price based on the current net asset value of [their shares] next computed after receipt of a tender of [their shares] for redemption or of an order to purchase or sell [their shares]... " This provision of Rule 22c-1 which ensures forward pricing also requires use of the next forward price (net asset value) computed - no matter how soon the NAV computation is made after the order comes in. This requirement for pricing immediacy is intensified by Rule 22e-2 which states that meeting the fund share sales, redemption, pricing and timing requirements of Rule 22c-1 is the way to avoid being deemed to have suspended redemption of the fund's shares.

At least three things: (1) investing cash purchase receipts, (2) selling securities to raise cash for redemptions and (3) unannounced changes in the composition of a portfolio that is subject to in-kind creation and redemption of its shares with previously posted baskets, simply do not work very well if the fund's transaction requirements and liquidity demands cannot be anticipated and certain steps taken before the NAV calculation is made. This anomalous effect of Rule 22c-1 determines the form of shareholder protective policies at certain funds. Interpretations of rule 22c-1 by the Investment Management Division of the Securities and Exchange Commission have been designed, candidly, to circumvent either the requirement that the forward price used be the next net asset value posted by the fund or the requirement that orders be accepted, literally, until the moment of the next net asset value calculation.22Ironically, the combination of Rule 22c-1 and the even more venerable requirement that a fund accept purchase and redemption orders each day until the market close has contributed to continuation of the very dilution of ongoing shareholders' investments that the move to forward pricing under Rule 22c-1 was designed to prevent.

Amplification of These Proposals

Market structures and practices develop constituencies. There has been and will continue to be vocal opposition to the firm 4:00 p.m. cut-off time proposal proposed by the SEC and others. This opposition is well-founded because a 4:00 p.m. cut-off, by itself, solves no problems. Interestingly, many organizations such as IBM (Simon (2003a)) and International Paper (Simon (2003b)) have already implemented 401(k) plan rules along the lines of an early order cut-off time to ameliorate the effect of purchase and sale orders on ongoing shareholders. Opposition to any structural change comes from many fund companies, proprietors of fund supermarkets, distributors and transfer agents. To illustrate problems these entities face, we note that the dominant system for assembling and forwarding fund orders is the Fund/SERV system operated by the Depository Trust and Clearing Corporation (DTCC). Fund/SERV now finishes processing fund share orders it receives in the middle of the night.23

The SEC is required to estimate the costs of its regulatory proposals to the entities it regulates. The Commission's cost estimates for its fund reform proposals leave large gaps and feature a number of "shrugs." In the last analysis, the Commission offers no comprehensive cost estimates. 24I readily acknowledge that the one-time industry-wide system costs of moving to a firm 2:30 p.m. cut-off will run to tens of millions of dollars if the order entry process is accelerated. Alternatively, simply deferring orders that do not reach the fund by 2:30 p.m. until the next day will add very little to industry costs. Improving fund shareholders' returns by anything close to $40 billion per year and rebuilding investor confidence must be the dominant considerations, whatever the cost.

To the extent that a change reduces turnover in some funds, the improvement in shareholder returns may come partly at the expense of individuals and entities involved in the fund share turnover process. They should be mollified by the proposal to accommodate any investor who wants to transact in the shares of a fund up to 4:00 p.m. on the current trading day. The investor would be able to go, directly or through a financial advisor, to a market maker unaffiliated with a fund's advisor and arrange to purchase or sell shares of the fund at a price linked to the 4:00 p.m. net asset value calculated that day. The market maker, rather than the fund's shareholders, would provide liquidity to facilitate these trades. The cost of this liquidity would be reflected in a trading spread or in a fee. Anyone who cares about immediate trading will be able to trade - at a price reflecting the cost of immediacy and liquidity.

If every mutual fund received all its fund orders by 2:30 p.m. and sent a wire or e-mail to the Securities and Exchange Commission by 3:00 p.m. listing its purchases and sales for that day, the necessary regulatory audit would be extraordinarily simple. Scope for the abuses cited in recent news stories would be negligible. The execution and audit process will have to accommodate same day exchanges from a fund in one fund family to a fund in another family at net asset value if the exchange order reaches both funds before 2:30. The easiest way to meet this requirement is to value the cash purchase (for order entry purposes) at the previous day's NAV for the fund being sold. The amount of the subsequent cash adjustment will usually be insignificant. A similar process for exchanges within a fund family will be even easier to implement.


Rule 22c-1 was a necessary and desirable reform at the time it was implemented. Recent developments have made it increasingly clear that Rule 22c-1's requirement that pricing be done almost instantaneously on a late arriving order is not in the interest of fund shareholders. Softening the late notice feature of the rule in the Investment Company Institute letter on fund exchanges25is clearly a step in the right direction and seems to reflect growing recognition at the Commission that the trading and pricing structure mandated by Rule 22c-1 is inappropriate and costly. Permitting independent market makers to accommodate investors who want to enter orders until just before 4:00 p.m. is a fairer solution. These specific investors, rather than all the fund's investors, will pay the cost of their trades.

B I B L I O G R A P H Y:

  1. Barbash, Barry P., "Remembering the Past: Mutual Funds and the Lessons of the Wonder Years," Transcript of Speech delivered at the 1997 ICI Securities Law Procedures Conference, Washington, D.C., December 4, 1997.

  2. Chalmers, John M.R., Roger M. Edelen and Gregory B. Kadlec, "On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option," The Journal of Finance, Volume LVI, No. 6, December 2001, pp 2209 - 2236.

  3. Ciampi, Peter and Eric Zitzewitz, "Fair Value Information Service White Papers," Financial Times Interactive Data, 2003. Copies may be requested from info@ftid.com.

  4. Der Hovanesian, Mara, David Henry, Amy Borrus, Paula Dwyer and Anne Tergesen, "How to Fix the Mutual Funds Mess," BusinessWeek, September 22, 2003, pp. 106 - 113.

  5. Edelen, Roger M., "Investor Flows and the Assessed Performance of Open-End Mutual Funds," Journal of Financial Economics, 53, 1999, pp. 439 - 466.

  6. Gastineau, Gary L., "Solving the Benchmark Index Exchange-Traded Fund Performance Problem," forthcoming in The Journal of Portfolio Management, Winter 2004.

  7. Goetzmann, William N., Zoran Ivkovic, and K. Geert Rouwenhorst, "Day Trading International Mutual Funds: Evidence and Policy Solutions," Journal of Financial and Quantitative Analysis, Volume 36, No. 3, September 2001 pp 287 - 309.

  8. Greene, Jason T. and Charles W. Hodges, "The Dilution Impact of Daily Fund Flows on Open-End Mutual Funds," Journal of Financial Economics, 65 (2002), pp. 131 - 158.

  9. Hulbert, Mark, "The Big Mo in Stocks Hits a Wall of Trading Costs," New York Times, Strategies Column - Business Section, August 17, 2003.

  10. Keim, Donald B., "The Cost of Trend Chasing and The Illusion of Momentum Profits," Working Paper, July 29, 2003, The Wharton School, University of Pennsylvania.

  11. Madhavan, Ananth, "Fair-Value-Adjusted Indexes," Journal of Indexes, Second Quarter 2003, pp. 32 - 37.

  12. Securities and Exchange Commission, Division of Investment Management: Investment Company Act Release No. 5413 (June 25, 1968) (proposing Rule 22c-1).

  13. ____________, Investment Company Act Release No. 5519 (Oct. 16, 1968) (Rule 22c-1 adopting release).

  14. ____________, Investment Company Act Release No. 13183 (Apr. 22, 1983) (proposal to adopt Rule 22d-1).

  15. ____________, Investment Company Act Release No. 14244 (Nov. 21, 1984) (proposal to adopt amendment to Rule 22c-1 concerning time of day of pricing).

  16. ____________, (July 24, 2000) (Order Exempting American Express Travel Related Services Company, Inc. from Broker Dealer Registration, File No. 4-436.)

  17. ____________, ReFlow Fund, LLC, No Action letter under: Investment Company Act of 1940 - Section 18(f), 22(d); Rule 12b-1, 22c-1, July 15, 2002(a), U.S. Securities and Exchange Commission.

  18. ____________, November 13, 2002(b) Letter to Investment Company Institute, Re: Delayed Exchange of Fund Shares, Investment Company Act of 1940 - Section 11(a) and Rule 22c-1, U.S. Securities and Exchange Commission.

  19. _____________, December 3, 2003, "SEC Takes Steps to Address Late Trading, Market Timing and Related Abuses," Press Release 2003-168, U.S. Securities and Exchange Commission.

  20. ______________, December 2003, "Proposed Rule: Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings," Release No. 33-8343, U.S. Securities and Exchange Commission

  21. _____________, December 2003, "Proposed Rule: Amendments to Rules Governing Pricing of Mutual Fund Shares," Release No. IC-26288, File No. S7-27-03, U.S. Securities and Exchange Commission.

  22. Simon, Ruth, "Fund Investors Face Early Trading Deadline," Wall Street Journal, December 17, 2003a, pp. D1 and D3.

  23. ___________,"The Crackdown on Funds Hits Your 401(k), Wall Street Journal, December 9, 2003b, pp. D1 and D2.

  24. Strauss, Lawrence C., "Scandal, What Scandal?" Barron's, December 15, 2003, pp. F2 - F3.

  25. Zitzewitz, Eric, "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," 19 Journal of Law, Economics, and Organization, October 2003a, pp. 245 - 280.

  26. __________, "How Widespread is Late Trading in Mutual Funds," Working Paper, September 2003b.

  27. Zweig, Jason, "The Great Fund Rip-Off," Money, October 2003, pp. 51 - 60.

I am grateful for the opportunity to present these comments to the Commission. If you have any questions concerning these comments, please contact the undersigned at 908-598-0440.


Gary L. Gastineau
Managing Director


1Zitzewitz (2003b) estimates the dilutive effect of such trading at about $400 million in 2001, less than 10% of his estimate of the dilution cost of market timing trades.
2 See Zweig (2003) and Zitzewitz (2003a).
3 Zitzewitz (2003a) notes that Greene and Hodges (2002) "regress buy-and-hold fund returns on market performance and the dilution for a particular (sic) and find a coefficient on dilution of 2.8. Giving this a causal interpretation would imply that the direct effect of dilution is less than half of the total negative effect on [shareholder] returns." To capture the negative effect on shareholder returns requires a different approach. Edelen (1999) provides that approach, as we document below.
4 See Hulbert (2003) for a summary discussion of Keim (2003) and an explanation of why fund timing may be the only refuge for momentum traders.
5 The no load classification is not necessarily important. Edelen was looking at fund performance for ongoing shareholders between two points, not the return realized by a shareholder from purchase to sale.
6 The Securities and Exchange Commission is implementing requirements for quarterly reporting.
7 The incremental cost of providing liquidity may be a slightly declining percentage of total flow trading costs because higher share turnover will mean that purchases and sales are more likely to offset one another. However, the manager of a $100 million specialty sector fund told the author that he came to work one morning some years ago to find that the clients of a timer had purchased enough shares late on the prior day to increase the size of his fund by more than 50% overnight. In this case there was no material flow on the other side of these trades and more than a third of the portfolio was, consequently, in cash the morning after the timing trades came in.
8 The magnitude of the cost is partly due to the fact that this liquidity is most commonly demanded when the market is moving at the close and the movement continues into the following day. Edelen's published figures were an abnormal negative fund return of 1.63% net of expenses vs. a negative return of .20% without the cost of providing liquidity. We use the net figure, 1.43%, here. One industry executive observed, when hearing the results of Edelen's analysis for the first time, that the performance penalty from in-and-out trading is "a lot bigger than that." Most similar studies have focused on opportunities for fund share traders to make a profit from this type of trading activity, e.g., Chalmers, et al. (2001), Greene and Hodges (2002) and Zitzewitz (2003a), and many of them focus on funds holding non-U.S. stocks, e.g., Goetzmann, et al. (2001) and Zitzewitz (2003a). The studies which try to determine whether a fund share trader can make money trading shares in a conventional fund that holds domestic stocks ignore certain trading costs that affect ongoing shareholders more than fund share traders. Edelen's paper is the only one we have found that looks directly at the ongoing investor performance effect. See footnote 3 Supra.
9 Estimates of the average fund's expense ratio vary widely. We found a recent estimate in Der Hovanesian, et al. (2003) of 1.44%, conveniently close to Edelen's net liquidity cost of 1.43%, but we could as easily have cited expense ratio figures from reputable sources ranging from under 1% to over 2%. One reason for the wide range is that calculating what the average fund investor pays requires weighting reported fees by fund assets and deciding what kinds of funds you want to include. Adding all the expense ratios up and dividing by the number of funds is easier. A consensus on methodology would be useful.
10 A fund accepting new investments.
11 Different times would be used on days with early market closings.
12 These rules would apply to all conventional funds except leveraged and inverse funds that use futures contracts to implement their equity positions. Those funds would be able to use a later cut-off time.
13 The ICI proposes a minimum redemption fee of 2% for positions closed out within 5 days. Bogle seems to be content with a 2% fee, but proposes that it be imposed on any sale within 90 days.
14 Since we considered such trades clearly illegal under SEC rule 22-c-1, we did not even ask about late trading. Inquiries about market timing of fund share purchases and sales today would surely get a more guarded response - at least temporarily.
15 The calculations behind these estimates are available from the author.
16 See Gastineau (2004) for an explanation and examples.
17 We do not use the example of a market on close or better order because we believe every fund should or will use this type of order to achieve an appropriately-invested position by the market close if the portfolio manager knows the fund's cash flows earlier in the day. The market on close or better order is easy for most readers to understand and it illustrates probable transaction cost savings relative to adjusting the portfolio on the following day.
18 Vanguard U.S. Stock Index Funds Prospectus. Similar language discusses their policy on redemptions. The prospectus further states, "Please call us before attempting to invest [redeem] a large dollar amount" (emphasis in the original).
19 We are probably talking about a difference of a basis point or two per year.
20 Apparently, the defense in some late-trading litigation will turn on the words "next computed" and the fact that many 4:00 p.m. NAVs are not "computed" until several hours later.
21 For more details on the Commission's position, consult Barbash (1997), Securities and Exchange Commission Investment Company Releases No. 5413 (1968), No. 5519 (1968), No. 13183 (1983) and No. 14244 (1984), American Express Travel Related Services Order (2000) and Securities and Exchange Commission (2002a) and (2002b).
22 For example, Securities and Exchange Commission (2002b) which permits funds that receive afternoon orders to exchange shares from one fund for shares in another fund in the same "family" to defer pricing the exchange to the next NAV calculation plus one.
23 Fund/SERV's operations are described briefly in SEC Release No. IC-26288,
24 These cost estimates for the current proposals can be found in SEC (2003b) and SEC (2003c). Most of the benefits from these proposals are only peripherally related to probable fund shareholder performance.
25 Securities and Exchange Commission (2002b).