Unraveling the Mysteries of Market-Timing

Subsequently, market-timers can also force portfolio managers to keep more cash on hand to meet the frequent redemptions. Alternatively, it also can force managers to invest large sums of money quickly. Either way, the portfolio is managed to meet the needs of the market-timers as portfolio managers contend with the rapid inflows and outflows -- rather than managed more thoughtfully on behalf of longer-term investors.

Some Wall Street firms have made the argument that because market-timers move in and out of the fund so quickly, their money simply remains a part of the fund's cash holdings and never actually gets invested in the market. But the profit that the market-timers make -- even if their flows don't prompt the manager to buy and sell securities -- still has a dilutive effect on the fund's shares. It's common sense -- if the market-timers make a profit, that profit comes out of the fund's assets. That is, it comes out of the assets that remain once the market-timers have exited.

Market-timing is usually described as a form of arbitrage, wherein traders take advantage of inefficiencies in the way mutual fund prices are calculated. This strategy is particularly used in foreign funds, which hold stocks that trade on exchanges that open and close at different times.

Here's how it works: A fund's net asset value, or NAV, is calculated once daily, at the market's 4 p.m. ET closing. The calculation is simple: The NAV is the current value of all the fund's investments divided by the number of fund shares.

So let's say a U.S. fund that invests in Asian stocks -- the U.S. Asia Stock Fund, we'll call it -- ends the trading day with assets of $100 million and 10 million shares outstanding, giving it a NAV of $10. Now, the next day, Asian stock prices decline 10%. The fund will also likely see its assets decline by 10%, giving it an NAV of $9.