In the storm of scandals that have engulfed American businesses for the last two years, the country's mutual funds industry appeared to be a model of high ethical standards. No longer. There are now serious investigations on into practices that allowed the US $ 7 trillion industry to allow some large investors to benefit at the expense of long-term investors.
In early September, the Attorney General of New York State charged a hedge fund—Canary Capital Partners—for resorting to 'late trading and market timing' in schemes floated by prominent mutual fund like Janus, Bank of America, Strong and Bank One. Late trading, as the name suggests, is the buying or selling of fund units after the closure of US stock markets. One of the ethical and fair rules of mutual fund investing is that any investment made after the close of business hours should get the next day's NAV so that its late entry does not dilute the profits of existing investors. The practice of late trading, although prohibited under SEC (Securities and Exchange Commission, the US equivalent of SEBI) regulations, can help an investor to buy or sell funds based on news, which comes after the end of business hours. Thus he can make profits next day either by exiting or by escaping the fall in NAV.
Market timing, the second questionable practice, involves benefiting from 'stale pricing' of some of the holdings of a fund. This involves investments in funds that hold non-US securities whose home markets close earlier than US markets—and practically every other market in the world closes earlier than the US. If the US markets have gained on a particular day, an investor may enter the foreign security at a 'stale price' anticipating a rise in international holdings of the fund on the next day. This is how Canary Capital has been accused of earning profits.
Though market timing (unlike late trading) is not expressly prohibited, both practices are detrimental to long-term investors. According to the accusations, these practices have resulted in a potential loss of many billions of dollars to investors. While the charges are yet unproven, the SEC has started its own investigation. In any case, the case has cast severe doubts on the ethics and business practices of the US fund industry.
Well, if it can happen in US, can it happen in India too? While stale pricing of foreign securities is unlikely for obvious reasons, it is not unimaginable that late trading can be happening here. The route that this probably takes is that of 'missed transactions', whereby a transaction is given an earlier NAV than it should be for the reason that the investor's original request went unheeded because of some clerical or communication or data processing error. Whenever the regulator gets serious about closing this loophole, it should beef up the procedures under which 'missed transactions' above a certain value are handled and reported.
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