Market timing: Implications for investors Down Under

The Australian and New Zealand funds management industries have certain features which would reduce the profits from arbitrage opportunities, including buy/sell spreads. But we aren’t necessarily immune to short-term trading.

Even US firms which assess redemption fees faithfully have sometimes reported encountering short-term traders. With typical Australian and New Zealand buy/sell spreads being less than US redemption fees, it is possible that short-term traders could be operating here.

Moreover, while most fund managers use forward unit pricing, which curbs the ability to engage in unit price arbitrage of international funds, a number of Australian and New Zealand managers still use – or have recently used – backward pricing, which is susceptible to market timing.

Indeed, we track data for scores of funds which allow investors to buy today at yesterday’s prices. That said, Morningstar is unaware of any specific cases in which local investors’ unitholdings would have been affected by stale unit price arbitraging.

There are however some indirect ways that the US fund scandals could affect Australasian and New Zealand investors.

Many local fund managers have chosen to outsource portfolio management of their international products to large, US-based firms such as Putnam, Fidelity, and Capital International. With Putnam, for example, evidence emerged that company insiders had profited on short-term trades. Although Putnam ultimately took decisive action, replacing its chief executive and six portfolio managers, we were nevertheless concerned about what these alleged misdeeds revealed about the firm’s culture and compliance practices.

Putnam has also lost the services of some talented investment professionals, may be distracted by ongoing investigations, and will undoubtedly spend enormous amounts of time attempting to retain remaining clients. (Putnam has already lost a number of significant mandates from US states’ retirement plans, as well as sustaining heavy retail redemptions.)

Lastly, there are lessons here for some Australian and New Zealand corporate superfunds, some of which allow cost-free switches among investment options – and could therefore be beset by short-term traders.

And on the sales side, many of the sales practices coming under scrutiny in the US, including various types of payment for so-called ‘shelf space’, could also attract the regulators’ attention in Australasia. <

MORNINGSTAR’S APPROACH

Morningstar considers these alleged misdeeds to be very serious breaches of the trust investors placed in their fund managers. In some cases, we have lost confidence in fund managers’ ability to invest clients’ assets in an ethical, responsible way. In those instances, we have recommended that investors and advisers consider liquidating investments placed with those managers, after taking into account relevant information such as transaction costs, possible tax consequences, and available investment alternatives.

Morningstar has made use of its global research network to arrive at decisions on managers offering products in local markets. For example, Morningstar’s decision to place a hold – and not a sell – recommendation on Putnam’s funds followed a series of frank discussions with Putnam and its local partner, BT Funds Management. Over the past few weeks, Morningstar held discussions with Jeff Greenberg, CEO of Marsh & McLennan (Putnam’s parent company); John Hill, chairman of Putnam’s US fund boards; Larry Lasser, Putnam’s former CEO; David Clarke, BT’s head of wealth management; Ed Haldeman, the current CEO; and a number of other BT and Putnam executives. Putnam and BT understood clearly the seriousness of this situation. Thanks to Putnam’s ultimately decisive action, Morningstar did not issue a global sell recommendation on Putnam’s products, wherever they are offered. Although it took time to conduct a dozen conversations with Putnam and BT, in both the US and the local market, we believe it is more important to gather all the facts – and make the correct decision – than to produce a snap decision based on press reports. (It’s also important to note that Australian and New Zealand investors’ monies were invested in pools separate from those Putnam US managed funds allegedly affected by short-term trading.)

In cases in which the fund manager has failed to take appropriate measures, Morningstar believes the benefit of the doubt accrues to the unitholders, not to the fund manager. For example, Spitzer initially fingered Strong Capital as one of the firms which had solicited Canary Capital, a hedge fund that engaged in profitable, short-term trading at the expense of Strong’s long-term unitholders. Strong did not react swiftly to the allegations, and it emerged later that the firm’s founder had himself benefitted from short-term trading in Strong funds. Morningstar has retained a sell recommendation on Strong’s funds since the initial accusations surfaced.

We ask a few key questions to differentiate among the firms which have been implicated. Was the behaviour confined to a few individuals, or was it widespread? Did senior management willingly sell out the interests of its unitholders? Or was it a case of a rogue employee violating company policies? Once the wrongdoing came to light, did management take swift and decisive action to remedy it? Have alleged wrongdoers been held accountable for their actions? Has the firm pledged to make restitution to affected unit holders? Do we believe that the institutional will exists to improve damaged cultures? What are the effects on investment personnel, both direct and indirect? And does the fund manager have other features, such as high fees, that mark it as hostile to unitholders’ interests?

We believe that asking these sorts of difficult questions can help us – and our adviser clients – arrive at well-considered decisions. There is no sign that the US fund scandals are about to end. But by analysing future revelations within an appropriate framework, we can make rational calls that are in the best interests of investors.

Scott Cooley is the chief executive of Morningstar in Australia and New Zealand.

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