The Canadian way

By Steven G. Kelman
Illustration: Mike Constable

Canada’s mutual fund industry differs from its counterpart in the US, where controls lag compared with the canadian system

Harmonization In late September, the staff of the Ontario Securities Commission sent notices of potential enforcement proceedings to mutual fund managers AGF Management Ltd., AIC Ltd., CI Fund Management Inc., and Investors Group Inc. The allegations concerned alleged market timing violations only and not after-market trading, which is a far more serious trading activity.

In fact the four companies, and virtually every other fund company in Canada, had introduced procedures to curtail trading based on market timing before the OSC began its probe in November 2003. Indeed, some companies had had controls in place for years. Moreover the OSC noted that to the best of its knowledge there had been no ongoing market timing activity since its inquiry began. Its investigation will continue as the OSC continues to review the information received.

The OSC probe is a reaction to investigations in the US where regulators had uncovered major problems involving deals between hedge funds and a significant number of mutual fund families.

The initial allegations of illegal trades in mutual funds were against Canary Capital Partners LLC, a New Jersey-based hedge fund, and its managing principal, Edward Stern. They were settled by an agreement to pay US$30 million in restitution and US $10 million in penalties.

While those sanctions were high by Canadian standards, they were soon dwarfed by fines, restitution and reduced fees that reportedly totaled more than US$2.3 billion by mid-2004 and involved more than a dozen firms. More settlements are likely, but it appears that US investigations are winding down.

While Canadian regulators are still collecting and analyzing data, industry watchers feel the Canadian industry is much different from that in the US and that the probe will find few problems.

OSC chairman David Brown’s November 2003 letter to 105 fund management companies asked them “to confirm that mutual funds have effective policies and procedures in place to detect and prevent trading abuses such as late trading and market timing.” Brown acknowledged there was no indication that US-type problems were replicated in Canada, “possibly because of a different market structure and more effective controls in our industry. We are working cooperatively with the mutual fund industry to address these issues to en-sure that mutual fund investors can have confidence in the industry.”

In february, the OSC completed the first stage of its investigation. “While it is premature to draw definitive conclusions, early results of the probe have not uncovered systemic abuses,” it said. This initial finding was no surprise to insiders. While Canadians may gripe about high mutual fund management fees and expenses, there appear to be no grounds for complaints about the industry’s integrity. Canada’s fund industry has in fact remained relatively scandal-free and regulatory problems involving mutual funds are few and far between.

Indeed many of the US problems were addressed by Canadian funds and regulators years ago and rising mutual fund sales in Canada this year suggest Canadian in-vestors care little about the investigation.

Specifically, last November the OSC asked fund management companies if they were aware of any late trading activities in their funds at any time in the past two years and to describe their policies and procedures to detect and prevent late trading. Those that reported late trading were asked to elaborate and disclose the source of the late trading and what actions had been taken to prevent further instances.

Late trading, or backward pricing as it is also called, is illegal. It involves filling orders received after the close of business at that day’s price rather than the next day’s. Generally, corporations release earnings and corporate news after the markets close. Good news often means the market will rise the next business day, conversely bad news can forebode a market decline. An investor who buys into a fund after the market closes in effect benefits from gains that belong to those who were securities holders at the market close. In the same vein, an investor who is able to redeem after the market closes having knowledge of bad news increases the im-pact of the bad news on the remaining in-vestors and avoids his or her share of the decline. As New York Attorney General Eliot Spitzer put it in his complaint against Canary, “Late trading can be analogized to betting today on yesterday’s horse races.”

Mutual fund management companies were also asked about market timing, which is legal but discouraged because it can boost a fund’s trading costs, allow some investors to profit at the expense of others and can disrupt a portfolio manager’s strategy by requiring the fund to hold greater cash reserves than would otherwise be necessary. Market timing usually involves someone taking advantage of price discrepancies between markets.

International funds are the most likely targets for market timing because of time zone differences. For example, a Japanese fund would be priced at 4 p.m. eastern standard time along with other funds. However, the net asset value per unit of the Japanese fund will be based on closing prices in Japan a half-day earlier. Any positive news released after the Japanese market closed would be reflected in the fund’s price a day later unless the fund made adjustments. A short-term trader could take advantage by buying fund units the first day and selling them the second.

The OSC investigation moved to stage two in February. It asked more detailed questions of a sampling of one-third the original fund companies. It requested a list of 2002 and 2003 trades for $50,000 or more that were back-dated or corrected or received after 4 p.m. and the codes of the salesperson involved and his or her dealer. The OSC also wanted details on all trades of $50,000 or more that involved a purchase followed by a redemption or switch within five business days.

The companies had to respond to the following question: “To the best of your knowledge, and after having made reasonable inquires, are you aware of any agreements or arrangements allowing anyone to trade frequently in fund securities and/or to trade after the close of business at the funds’ net asset value per security for that day? If yes, please explain.”

Given the magnitude of the US situation and the penalties imposed, some observers considered the OSC initiative weak, but most saw it for what it was: a means to confirm that Canada had a different market structure and better controls.

For example, the rules in both countries require that purchases and sales orders be placed before the markets close in order to be filled at that day’s price. However, the difference between the US and Canada is that in Canada the orders must be placed by 4 p.m. with the fund company or its transaction processor — for most funds that is FundSERV, which counts in its client base 193 fund manufacturers, 472 distributors and 42 intermediaries. As a result most Canadian dealers have an earlier cutoff point for placing orders for execution that day.

In the US, the order must be received by the dealer by 4 p.m. who then compiles the number of shares it is buying and selling and submits the order sometime after 4 p.m. eastern time, often hours later.

National Instrument 81-102, which governs mutual funds in Canada, is quite specific. Redemptions and purchases of funds must be at the net asset value “next determined” after the fund receives the relevant order. This is spelled out in parts 9.3 and 10.3 of the document. Moreover, the Companion Policy to NI-81-102 states: “For clarification, the Canadian securities regulatory authorities emphasize that the issue price and redemption price cannot be based upon any net asset value per security calculated before receipt by the mutual fund of the relevant order.”

The NI states a fund’s auditor must report to the fund’s provincial regulators that it has audited the fund’s compliance with the specific sections of the instrument dealing with the pricing of orders.

As for short-term trading, most canadian funds have policies to discourage it and include these policies in their simplified prospectuses. They can impose a transaction fee on securities redeemed within a specific number of days of their purchase or they can simply refuse orders.

Some Canadian funds will also use “fair valuing” and adjust the price of a security to its fair value to reflect such events as a change in price on a foreign stock in a foreign market, a trading halt, currency move or change in interest rates that would have an impact on fund unit values reducing the potential profit from short-term trading.

US authorities have proposed a few changes that will bring their practices more in line with Canada’s. In December, the SEC proposed a 4 p.m. cutoff for re-ceipt of orders by the mutual fund, its transfer agent or securities clearing. It also proposed that funds disclose their market timing policies and procedures, valuation practices and portfolio holdings — practices generally in place in Canada.

The SEC also proposed that funds charge a 2% fee on proceeds of shares re-deemed within five days of purchase, which goes beyond the Canadian practice and which many Canadian funds believe wouldn’t discourage short-term trading.

The SEC also proposed prohibiting funds from directing brokerage transactions to dealers as a means of compensating them for promoting or selling fund shares. Similarly, it proposed prohibiting arrangements where a portion of brokerage commission could be directed to an-other party for selling fund shares.

Such sales practices have been prohibited in Canada since National Instrument 81-105 went into effect in 1998. The in-strument was based on the IFIC code of conduct that was introduced in 1991.

There is no consensus among Canadian fund management companies about setting measures to discourage market timing and short-term trading in general other than the need for each organization to have procedures for monitoring trades. While some will charge a 2% redemption fee to discourage short-term trading, a 2% fee will have little impact if an investor expects to make a much higher return over a relatively short period. Fidelity and several other families use fair-value pricing for their funds. Fair-value pricing adjusts a stale price to reflect news that will have an impact on the price of that security when the market in which it trades next opens. Most US fund firms have moved to fair-value pricing and Canadians will do the same, if only to discourage US hedge funds from trading in Canadian fund units.

One area likely to be addressed by US and Canada soon is the use of “soft dollars” by mutual funds and other institutional investors. In effect, a fund company gives instructions that a portion of the commission it pays a broker be directed to pay for specific services from brokerage house research to third-party measurement services. These are not disclosed to investors. A report on the cost of governance by the OSC shows that in Canada, a soft dollar transaction costs 6¢ a share, compared with 3¢ a share for trades where soft dollar arrangements are not a factor.

Soft dollars are a conflict of interest between the fund manager and investor. There is the possibility that transaction costs can be inflated if the dealer doesn’t get the best price possible on a purchase or sale. It is impossible to determine if the fund that paid for the service with its com-mission benefited from that service relative to other funds in that fund family. A key argument against soft dollars is that an investor already pays a fee for a fund’s management. There’s no justification for a client to subsidize a manager’s operating costs by overpaying on transactions.