NEW YORK (CNN/Money) – Mutual fund timing — the controversial hedge fund strategy which plagued mutual funds and was stamped out by U.S. regulators — lives on offshore and could eventually come back to the U.S., according to a new report.
In a study titled “Hedge Fund Demand and Capacity,” Van Hedge Fund Advisors, a Nashville, Tenn.-based hedge fund advisory firm, found that a small number of non-U.S. funds are still running mutual fund timing strategies. The study’s authors also believe it could return to the U.S. once the regulatory drama over the 2003 scandal completely dies down.
George Van, chairman and founder of Van Hedge Fund Advisors, which authored the study, said that while mutual fund timing is virtually extinct in the U.S., there are still a number of firms practicing it offshore.
“It could pick up in U.S. – there’s no reason it shouldn’t except for the source of the strategy,” he said. “What’s going to hinder them now is resistance from the mutual funds (to permit short-term trading in their funds), but on the other hand, interest should return because it’s a good strategy. There is no reason why investors shouldn’t love it all over again.”
Van points out that he is not referring to the practice of late trading, which is illegal, but rather to “momentum” market timing, which he defines as investing short-term in mutual funds which are increasing in value. These funds trade based on a mathematical model that tells the manager when to invest in a given market and when to get out.
Van said the strategy is continuing to enjoy success offshore, because fund managers there are able to invest in mutual fund equivalents overseas, such as unit trusts in England. He adds that not every U.S. mutual fund firm penalizes short-term investments. (Rydex is one such firm that does not.)
Also, Van believes demand for these strategies is higher offshore, because investors there have not been as psychologically affected by the Spitzer scandal.
A subset of hedge funds in the U.S. practiced the strategy exclusively until September 2003, when New York State attorney Spitzer charged that some hedge funds had been allowed to trade after hours, and that several mutual fund operators, including Janus, Bank of America and Strong Financial, permitted hedge funds to rapidly trade in and out of those firms’ mutual funds, despite language in their prospectuses that clearly prohibited the practice.
One of the hedge funds Spitzer implicated, Canary Partners, cooperated with the investigation and settled with Spitzer for $40 million in fines and restitution. Steven Markovitz, a trader for New York hedge fund Millennium Partners, pled guilty to securities fraud for illegal trades.
Mutual fund timing occurs when traders try to profit from the short-term differences in the daily closing prices of a mutual fund. It entails buying a mutual fund that owns securities in a foreign market at the previous day’s net asset value, knowing events that occurred since that market closed will create an automatic profit. The practice is legal but frowned upon, because the rapid trading in and out of the funds results in higher costs for the fund’s shareholders.
The Van study concluded that the massive flood of new money into hedge funds, along with low volatility and tough market conditions, has driven down returns in many once-strong strategies such as convertible arbitrage. As assets increase, thereby increasing competition and eroding market inefficiencies, managers and investors are looking to niche strategies for outsized returns. Mutual fund timing was considered a niche strategy before it largely disappeared in the U.S. following the scandal.
“Late trading,” a separate but illegal practice, involves taking advantage of material information received after a market has closed and buying a security at that day’s closing price. Mutual fund timing is legal, though many mutual funds prohibit rapid trading in and out of their funds, making it difficult to practice. The regulatory furor over the mutual fund scandal caused many U.S. hedge fund managers running market timing strategies to close down.
The Van study examined the growth of hedge funds in the U.S. The U.S. hedge fund industry is believed to control about $1 trillion in assets between an estimated 8,000 funds. Among the study’s other findings:
The hedge fund industry is expected to reach $2 trillion by 2009 and $4 trillion by 2013.
The upcoming rule requiring hedge funds to register with the SEC as investment advisers is not expected to slow the growth of the U.S. hedge fund industry, and many offshore funds are expected to register in order to keep U.S. investors.
Leverage, or the use of borrowed money to enhance returns, is still low compared to historical highs. As of year-end 2004, 20% of hedge funds used no leverage at all and another 50% used leverage of less than one time their equity, including short positions.
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