I am researching historical practices of mutual fund market timing for
the period prior to September 2003.  This is an investment approach
that involves rapidly switching funds between an equity mutual fund
and a money market mutual fund.  Since September of 2003 there has
been an industry wide crack down on the practice of mutual fund market
timing and a number of mutual funds have paid large settlements to the
SEC to settle charges that they allowed market timing that was not in
the best interest of mutual fund shareholders.

The particular angle that I am researching is the extent to which
mutual fund market timing was an out in the open accepted investment
alternative in the months and years prior to September 2003. There are
two specific issues for which I would like research:

1. I am looking for documentation that demonstrates the extent to
which mutual fund market timing was a widespread practice prior to
September of 2003 as opposed to an investment technique just used by a
small collection of hedge funds.

2. I am also looking for documentation that would indicate whether the
regulatory bodies that are responsible for overseeing the securities
industry, such as the SEC, the NASD and the New York Attorney
General's office, were aware of the fact that mutual fund market
timing was a wide spread practice prior to September of 2003, or if
the regulatory agencies just had no idea that mutual fund market
timing was a widespread practice until just the last year or two.

Although both of these topics are related questions and likely could
be answered by a single researcher I would like specific and detailed
research on both topics.  Accordingly I am submitting this same
research question with 2 separate headings so that I can offer a $200
research project for each category of reference.

In this specific question I am asking for research on topic TWO:
documentation demonstrating the extent to which the regulatory
agencies either were are were not aware of the prevelence of mutual
fund market timing prior to September 2003.

Thank you for your help.

---

Request for Question Clarification by pafalafa-ga on 20 Jul 2004 05:04 PDT

Hello again s17-ga,

While I was researching this question, I came across some related
information that I thought would be of interest to you...I've posted
it below.

The information is from a federal court case regarding a mutual fund
market timing case that goes back to 1999, and it is one of the most
detailed descriptions of market timing that I've come across.

This raises a question:  Courts are (yet another) source of useful
information on market timing.  Perhaps you have more than enough
information on this topic already, given your numerous questions.  But
I did want to make you aware that there is at least one more
significant source of information out there waiting to be tapped.

Let me know if this is of interest to you.

pafalafa-ga

==========

I've provided extensive excerpts from the case, since (as a federal
government document) it is copyright-free and I am able to do so. 
However, I still suggest looking over the entire case at this link:


http://www.iasd.uscourts.gov/iasd/opinions.nsf/0/d35a1cdecae67dd786256de90059f792/$FILE/borneman%207-25-03.pdf


IN THE UNITED STATES DISTRICT COURT
FOR THE SOUTHERN DISTRICT OF IOWA
CENTRAL DIVISION
BORNEMAN
v.
PRINCIPAL SELECT SAVINGS PLAN

...Plaintiffs Brian and Melissa Borneman filed this action on July 12, 2002...

...Their claims arise from Principal?s imposition on Plan participants
of a restriction on market timing trading within the investment
accounts provided by the Plan.  Specifically, Plaintiffs have asserted
claims under 29 U.S.C.  § 1132(a)(1)(B) for recovery of benefits under
the Plan, under 29 U.S.C.  §§ 1132(a)(2) and 1132(a)(3) for breach of
fiduciary duty and invalidation of the market timing trading
restriction, under 29 U.S.C.  § 1140 for retaliation and interference,
and under 29 U.S.C.  §
1132(c) for failure to supply plan documentation.

...During the second half of 2000, Principal began to see high
fluctuations of cash flow in the separate accounts.  Toward the end of
the year, Principal came to the conclusion that market timing trading
was a factor in the fluctuations it was seeing.  Market timing
trading, in essence, involves shortterm trades between domestic and
international separate accounts.  Shares in Principal?s separate
accounts are repriced at 4:00 PM Eastern Standard time each day, the
time that the U.S.  stock market closes.  When a participant in
Principal?s 401(k) plan purchases shares in a separate account during
the day, the participant does so at the price prevailing at 4:00 PM. 
The 4:00 PM prices are calculated on the basis of the last traded
price of the stocks in that fund.  The prices for the international
separate accounts are among those that are recalculated at 4:00 PM,
however by this time the Japanese and European markets have already
been closed for some time.

...In an internal study, Principal found that the performance of its
international separate accounts on any given day was highly correlated
with the performance of the NASDAQ on the previous day, meaning that
the NASDAQ?s performance on any one day could be used, albeit perhaps
imperfectly, as a predictor of what would happen in the international
separate accounts on the following day.  The correlation between the
domestic markets and Principal?s international separate accounts
provided the opportunity for low-risk arbitrage between the domestic
and international separate accounts.  A participant could look for an
increase in the NASDAQ or another domestic market index, then purchase
shares in one of the international separate accounts that day.  The
participant would buy in at the price reflected at 4:00 PM, after the
relevant international markets had already closed and before the
international markets had responded to the NASDAQ increase.  Because
of the correlation between the NASDAQ and the international separate
accounts, the likelihood was that the foreign markets would increase
the next day, the value of the investor?s investment from the previous
day would rise, and the investor would then sell the international
shares to capture the gain and move his or her money back to domestic
investments to await another opportunity to invest internationally. 
As Principal did not charge fees for transfers between the separate
accounts, a participant would not incur costs as a result of these
trades.

...Principal decided that market timing trading was having a negative
impact on the performance of its international separate accounts.  To
deal with this issue, Principal decided to take steps to limit market
timing trading in the separate accounts of its various plans.

...As of January 2001, Principal had identified among its clients, not
simply within the Plan it sponsored for its own employees, 36 plan
sponsors and
80 individuals who were engaged in market timing trading.  The company
sent each of the affected plan sponsors a letter indicating that it
included members who had initiated an excessive number of one-day
transfers between domestic and international separate accounts.  The
letter asked each sponsor to voluntarily control the activity, and
indicated that if the market timing did not stop Principal would
enforce new guidelines limiting member transfers involving
international separate accounts to $30,000 per day.

...Plaintiff began engaging in market timing trading around September
or October of 2000.  Market timing trading was very profitable for Mr.
 Borneman.  He claims that during the first four months of 2001 he
earned approximately an 11% return on his account, in a market that
was down 20 to 25%.

...In February of 2001, Plaintiff and other members of his department
received an e-mail explaining that Principal, in its role as
investment manager to the Plan, was asking some of its customers to
stop excessive market timing trading by participants in their plans. 
The e-mail indicated, among other things, that market timing trading
increased the cost of portfolio management, increased brokerage
transaction costs, and decreased investment performance for all
individuals using the particular investment option being traded in
this manner.  Attached to the e-mail was a sample letter to customers,
which indicated that if the activity did not stop, Principal would
restrict market timing trading for each plan participant to $30,000
per day.

...Plaintiffs claim, pursuant to 29 U.S.C.  § 1132(a)(1)(B), that
Principal and the Plan have denied benefits due to them under the Plan
by restricting market timing trading in contravention of the Plan?s
terms.  The benefits denied, Plaintiffs allege, include lost past and
future investment earnings under the Plan; presumably, return on
market timing trading over $30,000 per day that Plaintiff Brian
Borneman could have engaged in had the market timing trading
restriction not been imposed.

...In the fourth quarter of 2000, approximately four to six months
before requesting that Brian Borneman voluntarily discontinue market
timing trading and approximately seven months before imposing the
market timing trading restriction, Principal came to the conclusion
that market timing trading was a factor in the high fluctuation of
cash flows in the separate accounts.  At this time, a group of
Principal executives discussed Principal?s options with respect to
market timing trading.  Three plans were discussed: 1) instituting a
lockout period, such that once a plan participant had made a
transaction within the separate accounts, further transactions would
be unavailable for a certain time period after the transaction
(specifically, Principal discussed a 30- or 60-day lockout period); 2)
charging high fees for the transactions, while continuing to allow the
trading to take place; and 3) putting a dollar limit on market timing
trading within the separate accounts.  Principal decided not to
implement either of the first two options.  A lockout period, it
feared, would discourage transactions and make its product appear less
attractive to employers who wanted to give employees the freedom to
invest money as they chose.
It decided against the fees for transactions systems because of the
costs and complexity associated with implementing such a system, which
Principal did not already have in place.  In making the decision to
implement a $30,000 trading limit, Principal looked at the actions of
peer and competitor institutions for guidance.

...Additionally, Defendants presented deposition testimony from one of
Principal?s vice presidents that market timing trading was hurting
non-market timing trading employees who invested in Principal?s plans.
 Other courts have recognized the deleterious effects of market timing
trading on a fund designed for long-term investment.  See Windsor
Securities, Inc.  v.  Hartford Life Insurance Co., 986 F.2d 655, 658,
665-66 (3rd Cir.  1993); First Lincoln Holdings, Inc.  v.  The
Equitable Life Assurance Society of the United States, 164 F.Supp.2d
383, 389-90 (S.D.N.Y.  2001).

...Additionally, Defendants have appended to their summary judgment
pleadings an article from April 2001 from Mutual Fund Market News,
entitled ?Insurers Try to Work with Market Timers.? Published
approximately two months before Principal imposed mandatory market
timing trading restrictions on its clients, the article helps to
clarify the context in which Defendant Principal was acting in order
to determine whether its actions qualify as those of a prudent person
under 29 U.S.C.  §
1104(a).  The article indicates the ?dilemma? of insurance companies
who want to provide flexibility to investors:

[W]hen excessive trading in and out of variable annuity sub-accounts
occurs, both sides get frustrated.  In many cases, managers are forced
to sell securities to meet sizeable redemptions, and then must rush to
reinvest those same assets when they come back into the fund a few
days later.  Fund expenses related to an increased volume of trades
can quickly drag down performance.  And, assets repeatedly moving in
and out of a fund can seriously disrupt a fund manager?s investment
strategy.

...Defendants also produced a letter dated June 15, 2001 from
OppenheimerFunds, which is addressed ?Dear Financial Advisor? and goes
on to note that the company has experienced a substantial increase in
short-term trading activities in the mutual funds managed by our
global equity team.  This has resulted in large day-to-day changes in
the cash positions of the relevant funds.  Short-term money movements
make the funds? portfolio managers reluctant to invest cash, which can
negatively impact the respective fund?s performance.  Similarly,
investing cash but then redeeming portfolio securities to satisfy
redemptions caused by short-term money movements forces the funds to
incur additional brokerage costs, to the detriment of long-term
shareholders.

...This letter is dated just a few days after Principal imposed its
market timing trading restriction and, as such, is reflective of what
was going on in the mutual fund market around the time the restriction
was imposed.

s17 --

A carefully researched and well-supported investigative report by
MSNBC.com documents that the Securities and Exchange Commission has
been aware since at least 1997 of the market timing practices that led
to the current investigations.  Its headline is: "SEC knew about dicey
fund pricing. Agency warned of problem for nearly six years, but did
little about it." That report is at this linked page:
MSNBC.com: Business: Corporate Scandals, by John W. Schoen (September 11, 2003)
http://msnbc.msn.com/id/3072548/

You have expressed in your previous questions your interest in
high-quality information instead of a high volume of barely (if at
all) relevant information, so I think that you will find this
exhaustively researched report and the online sources it documents to
be just what you are looking for.

The report is copyright-protected, so I cannot reproduce it here, but
for your convenience, I will focus on the documents on which it relies
and provide you with focused excerpts from those documents.  You will
certainly want to review the entire text of the report and possibly
the supporting documents for which I will provide links.

The lead paragraph of the report is:

"The Securities and Exchange Commission has known for nearly six years
about the sloppy pricing of mutual fund shares that one study
estimates is costing individual investors as much as $5 billion a
year, but the agency has initiated only a handful of low-profile
enforcement actions, a review of SEC statements and documents by
MSNBC.com has found."
MSNBC.com: Business: Corporate Scandals, by John W. Schoen (September 11, 2003)
http://msnbc.msn.com/id/3072548/


The first document on which the report relies is a December 4, 1997
speech  by Barry Barbash, the SEC?s director of investment management
division, to the  Securities Law Procedures Conference of the
Investment Company Institute ("ICI"), which is the mutual fund
industry's trade association.  Here is a link to the text of that
speech:
SEC: Speech Archive: 1997
http://www.sec.gov/news/speech/speecharchive/1997/spch199.txt

In his speech on this occasion, Mr. Barbash took note of  market
timing by "a fairly large number of [mutual fund] investors" using the
closing price differentials between the Asian and U.S. markets in the
turbulent wake of the October 1997 market crash:

"A striking finding of our recent exams, particularly in view of the
Commission's policy goals in adopting Rule 22c-1, was the extent to
which fund investors in October appear to have speculated in the
shares of funds investing in Asian securities. Our data suggests that
fairly large numbers of investors attempted on October 28th and 29th
to take advantage of the increase in funds' net asset values the
investors anticipated would occur as soon as subsequent market events
were reflected in the prices of the funds' portfolio securities. We
found that redemption fees assessed by some funds of up to 1.5% of the
amount invested did not deter this arbitrage activity, which promised
investors potential gains in double digits on those days."
SEC: Speech Archive: 1997 (about 4/5 down the page)
http://www.sec.gov/news/speech/speecharchive/1997/spch199.txt


The second warning from the regulators occurred in a letter of
December 8, 1999 to the ICI's General Counsel from Douglas Scheidt,
the chief counsel of the SEC?s Division of Investment Management.  
This letter is long, technical and lawyerly and contains no catchy
"sound bites," but it was clearly understandable to the professionals
at the ICI and in the mutual fund industry.  It warned that the
current pricing system (i.e., "net asset values" determined only at
the close of a session) invites speculation (i.e., market timing)
across time zones.  Instead it urges "fair value" pricing that takes
into account, among other things, different pricing factors in
different parts of the world

"We believe that a fund board, when fair value pricing portfolio
securities in an emergency or other unusual situation, should evaluate
the nature and duration of the event and the forces influencing the
operation of the financial markets. The board also should evaluate
factors relating to the event that precipitated the problem, whether
the event is likely to recur, whether the effects of the event are
isolated or whether they affect entire markets, countries, or
regions."
SEC: Investment Management: December Letter (about 1/2 down the page)
http://www.sec.gov/divisions/investment/guidance/tyle120899.htm


The third warning occurred in another letter from the SEC's Scheidt to
ICI's Tyle, this one dated April 30, 2001.  This letter is less
technical and more straightforward in its concern about the effect of
widespread market timing based on end-of-day pricing by mutual funds
that determine that determine their daily Net Asset Values at
different times of the day:

"Fair value pricing can protect long-term fund investors from
short-term investors who seek to take advantage of funds as a result
of significant events occurring after a foreign exchange or market
closes, but before the funds' NAV calculation. Attached as Exhibit 1
is an example that demonstrates how certain short-term investors, in
two days and at no risk to their investments, could profit by more
than $900,000, on a $10 million investment, from a small fund that
does not use fair value pricing. These profits would dilute the share
value of long-term investors in the fund. Although the value of the
securities held by both funds in the example would remain the same
after the market recovers from the short period of volatility, the NAV
of the fund that does not use fair value pricing would decline from
$10 to $9.82 -- a drop of nearly 20 cents per share for every
remaining shareholder in the fund, which is a direct result of the
actions taken by the aggressive short-term investors."

SEC: Investment Management: April 2001 Letter
http://www.sec.gov/divisions/investment/guidance/tyle043001.htm 

You may find the example outlined at the end of the letter at the
above link to be especially interesting insofar as it quantifies the
impact of market-timing arbitrage on long-term investors.


I believe that you will find that the information cited above provides
a compelling case for the proposition that the regulators overseeing
the mutual fund information were very much aware well before September
2003 of the prevalence of market timing strategies by mutual fund
investors.



Additional Information:

Although it isn't a direct indication of prior knowledge of the SEC
about the relationship of fund pricing practices to market-timing
strategies by fund investors, another pre-September 2003 academic
study the MSNBC report (I and other researchers have provided other
examples to you in response to a different question).  Here is a link
to an abstract of that study:
"Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," by
Eric Zitzewitz, Journal of Law, Economics & Organization, October
2003, Vol. 19 Issue 2, pp. 245-280
http://gobi.stanford.edu/researchpapers/detail1.asp?Document_ID=1789


Search Strategy:

I used various Google searches in my effort to find the information
and confirm its accuracy and completeness.  The most useful of those
searches was this one:

"mutual funds" "market timing" sec "was OR were aware:
://www.google.com/search?sourceid=navclient&q=%22mutual+funds%22+%22market+timing%22+sec+%22was+OR+were+aware%22


I am confident that this is the information you are seeking.  If
anything is unclear, please ask for clarification before rating the
answer.


markj-ga

Thank you so much for an exceptional answer!!

I owned a market timing firm from 1982 - 2001.  The regulatory
agencies never gave me any problems.  What I did notice is that Mutual
Funds did start putting rules in effect that would limit the number 
of trades per year. They did this NOT because of regulatory agencies
rules, they did this because fund timing was so big and it created
problems for the funds.  I solved this problem of limited trades by
placing my client's money into a Trust Fund and then invested the
money as one big sum of money.  The Trust company would have an
account at the mutual fund with, let's say, 10 million.  I would
invest an amount of say 3 million, making the balance 13 million.  I
could then switch the 3 mill around without being noticed.  I did this
with many different mutual funds.

I hope this gives you a little background on how it "worked".

s17 --

Thanks very much for the kind words, the five stars and the generous tip.

markj-ga