Written by Phillip Smith (Partner) and Kevin Brocklehurst (Registered Foreign Lawyer (Canada))


'Market timing' and 'late trading' have become hot topics since September 2003 when New York State Attorney-General Eliot Spitzer accused mutual funds of short-changing small investors by giving hedge funds special trading privileges.

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Mutual funds generally require investors to submit their orders to buy or sell prior to a specified dealing deadline or cut off time.

Investors pay or receive the fund's 'net asset value' which is determined once per day at the pricing or valuation point i.e. the exact time at which reference is made to the market price of a stock in the fund's portfolio.

Orders received after the dealing cut off time are supposed to be executed at the next day's pricing point. 

Late trading occurs when certain selected investors are favoured by being allowed to submit orders to buy or sell after the dealing cut off time.  Late trading investors receive 'backward pricing', that is, the price calculated at the pricing point that has already passed.

Late trading has been compared to placing a bet on a horse race after the horses have passed the finishing post!

Late trading investors benefit as they can make an investment decision based on the availability of price sensitive information affecting the underlying stocks.  

Market timers take advantage of these 'stale' share prices. Because some markets, especially in Asia, close hours earlier than in the U.S., the prices of those shares often don't reflect the latest news when the funds determine Net Asset Value (NAV) at say  4.00 p.m. Eastern U.S. time on the basis of closing prices at the end of the Asian trading day.

In market timing or front running, investors analyse the pricing point and the dealing cut off time and take advantage of time zone differences to, for example, buy or sell shares in a mutual fund they believe is about to rise or fall in value because of news affecting the underlying stocks and bonds held by that mutual fund - news that has come out after overseas markets have closed.

While not illegal, most funds claim to have polices and procedures aimed at preventing market timing trades, as such trades are felt to increase transaction costs borne by the fund and leave funds with unexpected pools of cash that cannot be invested because it must be set aside to satisfy redemptions by market timers.

Regulatory Reaction

The Securities and Exchange Commission in the United States has proposed a rule to prevent late trading by establishing a 'hard cut off' dealing deadline after which no backward pricing will be permitted.

Securities regulators in the United Kingdom, France, Germany, Italy, Canada, Switzerland, Luxembourg and Ireland have initiated probes into both late trading and market timing.

In Hong Kong, the Securities and Futures Commission (SFC) is studying late trading and market timing.

As most funds marketed to Hong Kong investors are domiciled in offshore jurisdictions such as Luxembourg and Ireland, any actions taken by the regulators in those jurisdictions may be sufficient to address any concerns the SFC may have in furthering its mandate to protect Hong Kong investors.

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