Nervy fund managers wait as FSA prepares to act on abuse

'Rigorous' interviews carried out by regulator as it investigates market timing
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The Independent Online

For the past two months, Britain's 25 largest fund managers have been dreading a knock on the front door. The Financial Services Authority, in many cases giving little more than 24 hours' notice, has been carrying out what have been described as "extremely rigorous" interviews with companies on the controversial subject of market timing.

For the past two months, Britain's 25 largest fund managers have been dreading a knock on the front door. The Financial Services Authority, in many cases giving little more than 24 hours' notice, has been carrying out what have been described as "extremely rigorous" interviews with companies on the controversial subject of market timing.

The FSA has been requesting - in the strongest terms - companies that have been quietly aware that market timing has taken place within their firms to come forward with the details.

The regulator has also demanded to know what safeguards companies have put in place to counter the effects of the practice on long-term investors, the group who most unit trusts are primarily aimed at, yet also the class of investors who are hit by its effects.

By the end of this week, the FSA's visits will have been completed. Fund managers will then have to sit and wait for the FSA's chairman, Callum McCarthy, to deliver his verdict on whether the practice, a form of arbitrage largely pursued by hedge funds, has been a common feature of share trading in the City in the past 10 years or so.

The watchdog's report is expected by mid-February. If the high-profile American investigation led by Eliot Spitzer, the New York attorney general, is anything to go by, British fund managers could be excused for feeling very nervous. Giants such as the Anglo-American investment company Amvescap have agreed out-of-court settlements with Mr Spitzer, who believes US investors are losing $4bn a year because of the antics of a few hedge funds. Others have gone further to try to mitigate Mr Spitzer's wrath - Putnam Investment sacked its chief executive and founder, Lawrence Lasser, and others have let senior executives go.

Clearly, the worry in the UK is that the FSA, which has taken much longer to launch its own investigation, could now be preparing for a similar showdown with British companies.

Richard Saunders, the chief executive of the Investment Management Association, the trade body which represents Britain's £233bn fund management industry, said: "It is almost certain market timing has taken place in the UK. But it is not yet clear at what level it will have been and whether it has had a material impact on other investors."

In common with many employees of the British fund management industry, Mr Saunders believes there is no smoking gun suggesting that "late trading" - related to market timing, but an extreme form which is illegal - has been a problem in this country.

Unlike in the US, late trading, where fund managers pretend a trade has taken place earlier than it really has done, is very difficult to commit in the UK.

While regulations in the States allow brokers a two-hour window to register a trade with a fund manager - enabling some to make up the time it has really gone through - in the UK the time of a trade is registered by the fund manager. This makes it very difficult for trades to be registered at false times.

A closer call for those awaiting the FSA's findings is whether the regulator will have uncovered instances of market timing executed at the real time but with the collusion of fund managers. While this is legal, it harms long-term investors because they have to bear the dealing costs created but not met by the hedge funds.

Under this scenario, hedge funds are able to persuade investment managers, because of the amount of business they are willing to place with the company, to waive some of the usual front-end charges, which are imposed on entrants to funds to cover the cost of dealing.

One senior fund manager said: "Usually it is in the form of a sweetener - a hedge bargaining to have fees waived on one fund and in return offering to put a slug of money in a different one, which means the fund manager can earn a few basis points."

Another possibility is for fund managers to relax "fair value" pricing. The policy circumvents the ability to base the market timing arbitrage on time delays by allowing managers to re-value, say, US equities, in anticipation of them rising when the market opens.

Even if the FSA is in a belligerent mood over market timing, it might be hard to throw the book at companies which have waived various charges because the charges are discretionary.

However, Simon Haslam, the chief administrative officer of Fidelity, says the regulator could have some leeway. "We use fair value pricing but not all unit trusts do. While it is not an explicit requirement under UK regulations, it is a requirement to act in the best interest of investors. So the FSA may come down on companies that do not use it," he said.

Even if the regulator believes it is on too shaky legal ground to crack down on past shady practices, it could certainly strengthen regulations in the future.

Robin Stoakley, the managing director of Schroders Investments, said: "The FSA could enforce fair value pricing, which would go a long way to eliminate investors trying to take advantage of stale prices when a market moves."

In terms of the current situation, the area where the FSA is likely to have its richest pickings will probably be in cases where market timing has taken place and fund managers have not even realised it. It is common knowledge that hedge funds have managed to slip trades under the radar screen of fund managers, either by investing money in sufficiently small amounts so as not to attract suspicion, or by using a nominee account, via a broker or life insurance company, which means they do not have to disclose their identity.

Almost all of the UK industry admits this form of market timing has taken place, and most have been privately telling the FSA that if it wants to stamp out the practice, it will have to strengthen regulations surrounding the role intermediaries play. One fund manager said: "At the moment fund managers have to take a lot of information about the underlying identity of investors on trust from the intermediaries, who, under the regulations, are not held responsible for market timing. So they will either have to hand over more information, or will have to be held responsible for guarding against it."

And in the meantime, cases could still go below the FSA's radar. Karen Ritchie, an adviser at Finance 4 Women, said: "The FSA is interviewing the top 25 fund managers and if it finds evidence of market timing their clients might receive compensation. But what about it if has happened at other fund managers? They will not receive compensation."

THE ESSENTIAL QUESTIONS

What is market timing?

Market timing is a form of arbitrage based on the fact that funds can be invested in equities listed on stock markets with different time zones.

Unit trusts are priced at 12 noon, and any investor buying or selling before then will get that price. If the fund contains US equities, they will be valued at their closing price from the day before, because American stock markets are not yet open. If a major event has taken place which is likely to affect the value of that stock, it is not reflected in how it has been valued by the unit trust.

Sophisticated investors can take advantage of the fact that they know when the US stock market opens, the price will soar, by buying into the unit trust. Having made a large profit, they then sell out quickly. The same applies to funds invested in Asian funds.

Why is the Financial Services Industry investigating?

Market timing is becoming increasingly controversial but it is not illegal. However, the process, used mainly by large investors such as hedge funds, can harm long-term investors, usually private individuals.

US regulators have already waged a high-profile campaign against fund managers who have used market timing.

The FSA says it will not ban market timing but instead wants to strengthen regulations so that private investors are not disadvantaged.

In practice, tighter regulations could stamp out market timing by making it more costly and time-consuming.

Why does market timing harm investors?

Fund managers have to convert cash handed over by an investor into shares within its portfolio. That involves a trading cost. Market timing is an abuse when fund managers do not pass on the dealing costs to the market timers, which usually invest large sums and want to enter and then exit a fund rapidly.

Who is most at risk?

As market timing takes advantage of time zones, those invested in overseas funds such as US or Asian equities are at risk. Those in funds based at offshore centres are also likely to be more exposed to market timing because regulations there are less stringent.

What is late trading?

Unlike market timing, late trading is illegal.

If anyone is found to have committed it in the UK, they would be likely to not only be fined but also be barred from working in the financial sector and probably prosecuted.

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