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Recognise and outline the trading behaviours at mutual funds that are undesirable.

FRM® Part I · Financial Markets and Products · Fund Management · FRM1.FM.3.b

The idea

Two trading behaviours harm the long-term holders of open-end mutual funds. Late trading means an order is accepted after the cut-off (typically the 4 pm close) but still filled at that day's NAV, so the trader uses news released after the close. It is illegal because it breaks forward pricing. Market timing is frequent in-and-out trading that exploits stale NAVs, for example a fund holding Asian shares whose prices are many hours old when the US NAV is struck. If the US market has moved sharply the timer buys cheap or sells dear against the stale NAV. It is not illegal in itself, but it transfers value from buy-and-hold investors and adds transaction costs. Funds respond with fair value pricing of stale holdings, redemption fees on short holding periods and limits on switching. The exam point is the distinction: late trading breaks the cut-off, market timing exploits stale prices.

A practice question

From the question bank, with the reason each wrong option is wrong.

A fund accepts a buy order at 4:45 pm and executes it at the NAV struck at 4:00 pm that day, after the trader has seen negative news released at 4:30 pm. What is this behaviour called?

  1. Market timingWhy not: Market timing exploits stale prices for orders placed before the cut-off; here the order itself is accepted after the cut-off.
  2. Front runningWhy not: Front running means trading ahead of a client's order using knowledge of it, which is not described here.
  3. Late trading - correct
  4. ChurningWhy not: Churning is excessive trading to generate commissions, not exploiting a past NAV.

Accepting an order after the cut-off at that day's NAV lets the trader use information the NAV does not reflect. This is late trading, and it is illegal because it breaks forward pricing.

A harder one

A US mutual fund holds Japanese shares whose closing prices are about 14 hours old when the fund strikes its NAV at 4 pm New York time. US markets rise sharply that afternoon, which suggests Tokyo will open higher. An investor buys the fund at that NAV and plans to sell in two days. What is the behaviour?

  1. Late trading, because the order is placed after the close in Tokyo.Why not: The order was placed before the New York cut-off, so it is not late trading.
  2. Arbitrage between the closed-end and the open-end structure.Why not: Nothing in the scenario involves a closed-end fund or a price gap between structures.
  3. Diversification into a foreign market at a fair price.Why not: The NAV is not a fair price: it is stale, which is what makes the trade profitable.
  4. Market timing, exploiting stale prices in the fund's NAV. - correct

The order is placed before the cut-off, so it is not late trading. The profit comes from NAV being based on old Tokyo prices, which is the classic form of market timing.

The hardest tier

A fund's NAV struck at 4 pm is 40.00. At 5 pm a firm is allowed to buy USD 500,000 of the fund at that NAV. Overnight news raises the fund's true value by 6 percent, to a NAV of 42.40, and the shares are then sold at that NAV. What is the gain from this late trade, closest to?

  1. USD 30,000 - correct
  2. USD 530,000Why not: Reports the final value of the position instead of the gain over the USD 500,000 invested.
  3. USD 28,302Why not: Divides the 6 percent gain by 1.06, treating the gain as a share of the ending value.
  4. USD 3,000Why not: Treats the investment as USD 50,000 (a decimal slip) when applying 6 percent.

Shares bought = 500,000 / 40.00 = 12,500. Sale value = 12,500 x 42.40 = 530,000. The gain of 30,000 is 6 percent of the investment and is taken from the other shareholders.

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