TCS Daily

Losing Ground at the SEC

By John E. Tamny - August 13, 2004 12:00 AM

In his 1985 classic, Losing Ground, Charles Murray tried to create a government incentive program that would cure a perceived societal ill. His hypothetical was "The Comprehensive Anti-Smoking Act," and it would pay one pack-a-day smokers who'd been smoking for at least five years $10,000 if they quit for one year.

His point was to show how truly impossible such plans are to devise.

Indeed, the incentives offered by the Anti-Smoking Act sound great until you consider their unintended consequences. Leaving aside all the cheating and relapses, what about all those smokers who haven't been smoking for five years, but who continue their pack-a-day habits in order to reach the five-year mark? Would the program cause moderate smokers to up their daily intake to one pack, and wouldn't it be more difficult to quit at five years rather than at two, three or four years? The questions are endless, and are a reminder to politicians of how hard it is to use legislation to achieve a certain desired behavior.

The August 2nd Wall Street Journal reported that the SEC is discovering this now as it tries to restrict rapid trading in mutual funds in the aftermath of the market-timing scandals. The SEC has proposed a 2% penalty on mutual fund shares redeemed within five days of purchase.

At first this might sound fine, but what happens when an investor hears bad news about a fund just invested in? Buyers of real estate have three days to change their minds, but under the new plan the small investor who has the temerity to change his mind would be hit with a 2% exit fee. Markets are volatile, and what if they take a dive upon entry to a fund? Doesn't the investor have the right to move his funds out? Should funds benefit from these exit fees when it was supposedly the funds themselves that were doing badly by shareholders to begin with?

To solve the above, one "solution" involves allowing those with accounts under $250,000 to be exempt from the 2% proposal. That sounds nice, and on first glance might seem favorable to the small investor. The problem is that mutual funds (as do all money managers) rely on large accounts for the fees they generate.

If 2% only applied to large accounts, then large investors would certainly flee. Who's going to risk a 2% hit on a big position in ever changing markets? This might cheer those who say the presence of large accounts (market timers and such) hurts the small investor, but absent those large accounts, someone is going to have to pay the bills of the mutual fund that suddenly has less money under management. Higher fees loom if the reforms go through.

The same concept applies to hard 4 PM closes on mutual fund orders. This is all well and good, but pity the small investor on the west coast who doesn't get his order in by 11 AM. Odds are he'll miss that day's final price, and potentially, that day's rally.

Soft dollars? Seen by some as an unseemly way for smaller funds to pay for everything from office furniture to Bloomberg machines, soft dollars also enable money managers to access non-Wall Street independent research. Not too long ago this was thought to be a priority by a number of actors, including Eliot Spitzer. The August 3rd Wall Street Journal reported that "buy" recommendations of independent research firms outpaced those of the major investment banks by 8% from 1996 to 2003.

All of the above is being proposed to supposedly correct past practices such as market timing and timed trading. Fine, but what about them? Market timing and timed trading certainly could have diluted the returns of long-term shareholders, but we haven't seen much proof. We've heard stories about profits "generated" by market-timers, but a wildly successful money manager who ought to know, Ken Fischer, has pointed out that according to his sources in the legal profession, market-timers as a whole lost money; meaning long-term investors must have gained.

All this leaves aside one of the fundamental complaints against timers; that they forced money managers to keep investable assets on the sidelines. Considering market-timing was most prevalent during the worst bear market since the '30s, it seems logical that someone in the investment journalism field would have asked by now how it was that long-term investors were hurt by timing arrangements that kept investor assets shielded from the aforementioned bear market? Would mutual funds even accept timers during a bull market? Would they even need the extra assets? Think about it.

Throughout the nearly yearlong mutual fund scandal, one truth that's been acknowledged by all is that performance is what attracts investors to mutual funds. Knowing this, and knowing that there are 8,000+ funds competing for assets, even the regulator with the most basic knowledge of economic reality would have to agree that the markets are a real alternative to more regulation.

Some funds will allow timers, some won't, some will charge 2% redemption fees, and some won't. Importantly, funds will face economic consequences in all that they do and will adjust accordingly. This has to be a major improvement on the present solution that supposes all investors have the same needs.

The new rules being offered by the SEC, much like the mythical "Anti-Smoking Act," assume that there exists a regulatory answer for all the supposedly undesirable situations that we face. It's a flawed assumption, and one that will arguably harm the very people it's intended to help.

John Tamny is based in Washington, DC and can be reached at


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