NEW YORK -- As regulators deepen their probes into illegal trading by mutual funds, investors are learning more about potentially shady practices that can hurt their returns. Fortunately, they have ways to protect themselves.
In recent weeks, New York Atty. Gen. Eliot Spitzer and the Securities and Exchange Commission have said they are investigating "market timing" of fund shares, a practice they say costs investors billions of dollars.
People often seek to time the market by seeking to buy individual shares when they're low and selling when they're high. But market timing in mutual funds -- or short-term "in and out" trading -- can be particularly harmful, since the transactions often hurt other investors in the fund.
"It's a big concern," said Roy Weitz, publisher of FundAlarm.com. "Market timing is basically a hidden expense ratio. If you have a 1-percent expense ratio and a 1-percent loss to market timing, that's a lot of money."
Still, defending against market timing can be tricky. That's because the practice is legal, unless a fund's prospectus bans it. In addition, firms don't always offer safeguards, as they are seeking to attract, rather than discourage, investments.
Analysts say the best approach is for investors to find firms that prohibit timing and offer protections -- particularly for international funds, where market timers often seek to take advantage of time-zone differences to garner quick gains.
In addition, they say, other factors, such as fund expense costs or a manager's length of tenure, could offer signals to investors as to whether their best interests are being served.
"The basic issue is one of trust. You have to feel good about the firm you're investing with," said Jeffrey Ptak, mutual fund analyst at Morningstar Inc.
Spitzer has accused hedge fund Canary Capital Partners LLC of market timing involving Bank of America, Janus, Bank One Corp. and Strong Financial Corp. funds. And Alliance Capital Management Holding LP suspended two employees last week for alleged market-timing transactions.
Market timers can hurt long-time investors in several ways. A series of transactions in and out of a fund can increase the commissions that managers must pay to buy and sell securities, and that eats into returns. Quick withdrawals also can force managers to sell winning investments. And managers anticipating many withdrawals may hold a larger cash reserve than would otherwise be necessary.
International funds, in particular, tend to offer good market-timing opportunities because of the time differences.
Funds typically calculate their share prices based on the value of their securities once daily, after the 4 p.m. Eastern time close of markets. That means an investor could trade in a U.S. fund holding Japanese shares even though the Tokyo market had closed hours earlier.
So, if U.S. stocks are rallying, an investor can buy shares in that international fund, on the expectation that Tokyo will rally the next day, and then make a quick sale for profit.
To combat that, some firms, including the Vanguard Group, T. Rowe Price and Capital Research & Management Co., use "fair-value" pricing to factor in more up-to-the-minute information on major market-moving days. So if U.S. stocks plunged, investors couldn't as readily take advantage of the time difference to escape a likely selloff in the Japanese markets the next day.
"I would be more vigilant about timing if you had a fund with significant foreign holdings or holdings with potentially less liquidity, such as a small-cap or high-yield fund," Ptak said. "Usually, you can find out if firms do fair-value pricing either in the prospectus or in the annual report."
Other defenses include redemption fees and limits on trades.
Vanguard, for example, imposes fees -- including a 2-percent charge on international funds held less than two months, as well as fees for sector funds -- to deter short-term trading.
The company also places trading restrictions that prevent investors from moving out of an index or international fund more than twice a year, according to Vanguard spokeswoman Rebecca Cohen.
"I don't think investors should be tossing and turning at night worrying about what market timers are doing to them," Ptak said. "It's one thing investors might want to do, when kicking the tires on their fund."
