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Abstract
The current and ongoing controversy that has come to be known as the "Mutual Fund Scandal of 2003" was based in large part on abusive market timing activities that were allowed to occur in select mutual funds. There are many ways in which a market timer can steal profits through short-term trading activities but the primary opportunity arises in those mutual funds that invest in foreign shares of stock. This 2004 article looks at a sampling of those mutual funds that invest in companies based in the United Kingdom and evaluates the potential for abusive market-timing activities.
What is Market-Timing?
Market timing is the practice of rapidly buying and selling mutual fund shares to take advantage of "stale prices" of foreign shares of stock. US mutual funds that buy foreign stock shares are priced at the end of New York trading, many hours after foreign markets close. If US markets rally during the day, it often happens that foreign stock prices will rise tomorrow. Market timers buy today, knowing that the funds are undervalued, and then sell them the next day, when they rise. Market timing is not illegal but most mutual fund companies prohibit the activity because it skims profits from long-term investors (SEC-A, 2004).
Market timing is a difficult undertaking at best. It can be effectively used by only the most sophisticated investor and, to be profitable, it requires large sums of money. A potential market timer must first know the precise stock holdings in the mutual fund he or she targets for a "round trip" and this information is not readily available to the average investor on a daily basis. The successful market timer must also know, or be fairly certain, how a particular foreign stock or industry will react to US market news the day after it occurs. Finally, because mutual funds are usually well diversified with any particular stock holding comprising two percent or less of the total mutual fund's holdings, the investor must be willing to invest a large sum of money in the hope that the mutual fund share price will rise more than a few pennies in order to turn a quick profit on the subsequent sale. Even if all these circumstances do come together...