Saturday, January 12, 2008

Trading Places

Back in 2003, when then-New York Attorney General Eliot Spitzer launched his investigation into mutual fund trading practices, two distinct areas were highlighted: late trading, which was illegal on its face (particularly so when facilitated by the fund companies themselves), and market-timing, which, as we were reminded in a parenthetical comment in nearly every story regarding the scandal, was not (though nearly every fund prospectus claimed to discourage such patterned trading and promised to take steps to deter it).

That distinction was frequently glossed over in the coverage that followed—and the settlements that ensued. When all was said and done, a large number of chastened fund complexes had forked over a large amount of money (much of it to the coffers of the Empire State) and agreed to adopt new controls and procedures designed to ensure that the wrongdoing they never admitted to doing never happened again. So much commotion was raised, in fact, that the Securities and Exchange Commission was roused from its slumbers—just in time to adopt a “solution” to the problems resulting from the not-illegal-but-nonetheless-apparently-troubling practice of market-timing. Of course, the solution—initially set forth by a trade group that represents the mutual fund industry—was already available to those fund companies. But now, thanks to the codification in SEC Rule 22c-2, even the most casual mutual fund investor—including those who do so only via their 401(k) plan—has been forced to be aware of redemption fees—and we’re not just talking about cases of quick in-and-out, round-trip trades, either.

Setting aside what, IMHO, is still an absurd result, it’s all old news by now. Been there, done that, bought the T-shirt….

Here We Go Again

That’s why it’s been interesting to watch the debate over market-timing once again raise its ugly head—this time among the participants of the federal government’s own Thrift Savings Plan, or TSP. Apparently, there are a couple of thousand participants (out of a universe of 3.8 million in the TSP) who are trading “frequently”—and the TSP is taking steps to rein them in.

The Washington Post has reported that 2,018 participants who sold holdings in an international fund on October 24 had transferred in just a few days earlier (10/19). And, of that group, 323 participants were trading $250,000 or more. Moreover, during the previous 60 days, those 323 traders had made 5,804 exchanges in the international fund worth $1.9 billion, according to TSP officials (one participant has traded more than $1 million back and forth a number of times). These participants aren’t trading in mutual funds, of course, so the SEC’s 22c-2 strictures don’t apply.

Moreover, an analysis by (a Web site devoted to federal workers) claims that those who bought in on 10/19 did so at $25.13/unit, and those who sold on 10/24 did so at $25.32/unit, making 19 cents per unit in just a few days. A feat that looks pretty good until you consider that, at 10/31, that particular TSP fund closed at $26.31.

But the TSP’s issue isn’t with the money these folks are making on those transfers. Rather, they are concerned about the cost impact of that activity on the folks who don’t trade; higher broker fees and transaction costs—especially in the international fund, where it's more difficult for the TSP's investment manager (BGI) to match buy and sell orders. They have—rightfully as fiduciaries, IMHO—expressed concern that a (relatively) few participants are driving up the costs for the vast majority who, like their counterparts in the private sector, never trade. Those trading costs stand out in the TSP, which enjoyed a total expense ratio of 3 basis points (that’s not a typo) in 2006. The trading costs for their international fund that year? Eight basis points (again, no typo). Now, those expense ratios may be a “problem” that your average 401(k) would love to have, but we’re talking about a $235 BILLION dollar fund. So, in crafting a recommendation to deal with this situation, the TSP’s chief investment officer looked to—mutual fund practices in the 401(k) industry and the SEC’s mandate under Rule 22c-2. Ultimately, unable to come up with a transaction fee that would be big enough to cover the trading costs, the TSP has decided to impose limits on the number of trades per month. Those limits—two per month—should be enough to satisfy anybody who isn’t trading funds for a living. Moreover, the TSP has imposed NO restriction on transfers from any of the funds to the G fund, the TSP’s most conservative option, to address the concerns of participants who might want to move their balances out of the way of some economic tsunami. More importantly, IMHO, it sends a message both to those participant-traders and to “everybody else.”

I also was struck by the TSP’s comparison of their solution with that adopted by the mutual fund industry. Though we frequently bemoan the bane of participant inertia, our industry has long been concerned about participants that would fritter away their day—and their balances—trading their retirement savings. That was the mantra against daily valuation in the first place, why we fretted over day traders in the middle of the tech-bubble, and, now, why a relatively few market-timers (setting aside for a minute that the incidents taken to task by regulators involved the complicity and/or active acquiescence by the fund companies; let’s face it, we all know the odds are against participant timers) have managed to burden an entire industry with an additional layer of costs, another complicated message, and random restrictions.

I can understand why the fund managers are in favor of these impediments. I’m (still) not altogether sure why the rest of us have been so willing to go along.

- Nevin E. Adams, JD


In the interim, a group calling itself TSPSHAREHOLDERS.ORG has launched a web site and a petition campaign to block the new transfer policies – and they have just under 3,000 signatures on that petition (one can’t help but wonder if it’s the SAME 3,000 that have been doing the frequent trading). They have some issues with the calculation of trading costs – and they claim that the big trading surge last October resulted in a “tracking error” (basically a difference between the price at which transfers were credited and the real cost of the transaction) – and they claim that the tracking error accounted for 56 basis points in the favor of those who stayed in the fund (see

Now, what’s missing in that analysis, of course, is the reality that that tracking error COULD have cut the other way – and those left sitting in that investment fund could just as easily have been stuck with a loss. But then, that’s how free markets work. Some people win and others don’t (what’s also more than a bit ironic, IMHO, is that up until the past couple of years TSP participants could only transfer once a quarter).


  1. Mr. Adams:

    TSP is not a mutal fund. It's different, in that the only shares are index funds. Barclays is the fund manager, and they got an exemption from the SEC back in August to allow the use of ETF's and covered calls in conjuction with the daily fund reallocations of TSP share holders.

    The costs of "trading" is minimal, as you so aptly point out. We're talking less than 3 basis points on the most expensive fund- the I fund. And the real costs are really attributable to the daily 4 p.m. fair value calculation, rather than waiting until 7 a.m. nteh next morning, after share are actually sold, to value the share price.

    Unlike mutual funds, TSP also has a noon cutoff for a trade executed for COB that day. So Barclays knows well before the market closes what the dollar amount to be changed will be.

    There is no shady deals going on here. Simply put, making interfund transfers within the TSP is a much better value, is well executed, and people should have the right to move their own money as they see fit.

    I urge you to look closely at the cost figures being bantied about by the Thrift Board. The recently appointed CIO - Tracey Ray, comes from the "buy-and-hold" world, and can't understand the differences between mutual funds, and the funds she is now holding fiduciary responsibility for. Our movement of funds is NOT costly. As you pointed out, 2006 costs fell to less that 3 basis points overall. And 2007 will turn out to be around ONE basis point, even with all that "trading" you cite.

    You note TSPSHAREHOLDER.ORG's data from October. Let's look at the whole year before then:

    What other fund can do this?
    January through September 2007:

    F Fund: (Bonds)
    Amount Traded: $6.9 BILLION.
    Cost to trade: $766,953
    No, that's not a misprint.

    C fund: (S&P 500)
    Amount traded: $8.4 BILLION
    Cost to trade: $780,000

    S Fund (Wilshare 4500)
    Amount traded: $7.08 BILLION
    Cost to trade: $699,969

    I Fund: (EAFE index)
    Amount traded: $19 BILLION
    Cost to trade: $12 million.

    But that's only part of the true value here. A fund would be successful if the fund matches the performance of the index it is supposed to track.

    Because of the management of Barcalys, the techniques of using covered calls and ETF's to supplement actual trades, Barclays has managed to get BETTER RETURNS BECAUSE of trading:

    For instance:

    January through September 07:

    F Fund: Beat it's index by 6 basis points.

    C fund beat it's index by 3 basis points.

    S fund beat it's index by 15 basis points.

    I fund beat it's index by 22 basis points.

    That was through September. October they had a bonanza as traders notched up the movement of funds, and , as you note, the I find jumped in beating it's index through Fair Valuation changed- skimming off pennies from the traders, and boosting the BUY AND HOLDERS returns. Now it up to 56 basis points for the year to date.

    So tell me- Why is this bad?
    There is no downside. There is only a single CIO, who isn't familiar with the TSP, who now wants to put limits on trades. She is scared to death because she sees a boost in volume of dollars traded. But costs are FALLING, not rising, and retuns are INCREASING, not decreasing.

    TSP Trades benefit EVERYONE. Why do you knock it?

  2. You wrote:

    "Eight basis points (again, no typo). Now, those expense ratios may be a “problem” that your average 401(k) would love to have, but we’re talking about a $235 BILLION dollar fund. "

    That is not correct. The 235 billion number is the amount in ALL TSP Funds, not just the I fund. Overall, for the 235 Billion, this year the "costs" are the lowest in the history of the TSP.

    Total costs are now running at just 1 basis point for the entire 235 Billion, and the costs for the I fund - year to date as of October 2007, is just 5.8 basis points, on a fund balance that is about 23 billion.

  3. First off, I realize that we're not talking about a mutual fund - if we were, there would be no issue, because the 22c-2 rules would make this a moot discussion.

    I also reallize (as I noted in the footnote) that the real costs at issue seem not so much to be transaction/trading as they are the results of a timing difference in calculating the unit values and applying them. That, by the way, was a very similar issue with international mutual funds, and in a previous post, I suggested that a better solution to the market-timing issue on such funds would simply be to apply the real prices to the real trades rather than using such "fair value" estimates. I still feel that that is the best solution in such cases - and much prefer it to any kind of artificial trading restrictions.

    I did not realize the funds had a noon cut-off. However, I don't know that that helps the fund manager much - after all, those markets are running on a very different schedule.

    I continue to think that, at least in the way that the funds are run now, the frequent trading has the potential to hurt those who aren't trading - and the TSP Board has a responsibility to look out for everyone.

    What may bear a better look is the rules the fund manager has imposed, rather than how people have figured out a way to profit from it.

    IMHO, instead of claiming that the current system/approach inherently works to the benefit of all, I think it would be better to acknowledge that that has really been just a happy coincidence. I do think that the TSP board has put forth a decent compromise between the current trading practices of some and the current processing strictures imposed.

    However, and as I said in my closing comment - I can understand why the fund managers are keen on these kind of limitations - I think the better position for those who want to have no (or fewer) limits on their trading is to ask why those strictures are in place and appropriate.

    Thanks for your comments.

  4. Indeed, the $235 billion figure is the entire TSP - and the 8 bp figure relates only to the international fund in the TSP. However, my sense in such matters is that the TSP probably gets a better rate on the trading costs from the fund manager because of the size of the overall relationship. It may not, of course, and I should have been clearer that the numbers applied as noted above.

    Thanks for your comment.