Unraveling the Mysteries of Market-Timing

Beverly,

In your article Time to Sell Strong Funds?, you mentioned (and I have heard a lot of talk about this from other articles) that "market-timing" and turnover in mutual funds raises the costs to the fund and hurts performance. How can that be when all trading costs and expenses are built into the expense ratio? Would it not just cut into the fund's profitability as it relates to the fund company only?

-- J. Hanahan

We've received a number of questions regarding the specifics of market-timing and how it hurts funds. But before we get into a thorough explanation of market-timing, let's look at the issue of fund expenses.

A fund's expense ratio (which you can find in the fund's prospectus or on sites such as Morningstar's) does not include all the fund's costs. A major omission from that figure is the fund's trading costs. When the fund manager buys and sells a security, he or she pays a commission on that trade. But while trading costs are not included in the expense ratio, they most certainly come out of the fund's total return -- they are subtracted directly from its assets, shrinking the fund's gain or deepening its loss.

In addition to the specific fees managers incur when trading, funds can also suffer market-impact costs. When a fund manager sells a big stake, it often causes the stock price to drop by essentially creating excess supply. That means that the stock price continues to drop as the fund continues to sell. A similar problem can happen on the buy side as well -- managers looking to purchase a large amount of a security can drive its price upward as they continue to buy.

In either scenario, the fund's shareholders lose as the underlying securities are either sold too low or bought too high. That's why most fund companies spread out their trades and buy or sell strategically. But when market-timers are entering and exiting a fund within days, the fund's trading staff may not have time to employ the best strategy. That's particularly true when the underlying securities are illiquid.

Frequent trading also leaves a wake of tax inefficiencies -- a burden only the remaining shareholders will be forced to carry.