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Unintended consequences

The SEC's revised edict on rapid trading is hastening changes in the relationship between mutual fund companies and retirement plan service providers.

In the three years since former New York State attorney general Eliot Spitzer first blew the whistle on market-timing abuses at mutual funds, regulators have struggled to fashion a comprehensive response. The main stumbling block has been the widespread use of omnibus accounts, in which successive levels of intermediaries net trades before they are forwarded to mutual funds for execution. The efficiencies of omnibus accounts make it more practical and profitable for fund companies to serve defined contribution plans -- but the aggregation of trade orders can mask the identities of abusive traders.

In September, after much revision and delay, the Securities and Exchange Commission issued the latest version of an edict on rapid trading known as Rule 22c-2, extending the deadlines for compliance. By April 2007 mutual fund firms must develop policies on whether to impose redemption fees, which the SEC believes can curb the appeal of prohibited trading. The rule also declares that by October fund companies must strike information-sharing agreements with retirement plan providers, brokerages and other intermediaries. This provision seeks to empower mutual funds to identify investors in omnibus accounts whose short-term trading violates their restrictions.

At a fund's request, intermediaries must be prepared to provide taxpayer identification numbers and transaction information in cases of suspicious trading and to execute instructions from the fund to restrict purchases or exchanges.

"The goal is to pierce the veil of omnibus accounting in the hope that we will maintain the efficiencies while diminishing the hazards," says Robert Plaze, associate director of the SEC's division of investment management.

Finding that balance has been difficult. An earlier iteration of the rule left the definition of "financial intermediary" uncomfortably vague, raising the possibility that fund companies would need to negotiate information-sharing agreements with every type of intermediary, including small-business retirement plans with just a few participants.

To eliminate that burden, the SEC has exempted intermediaries that a mutual fund treats as individual investors for purposes of enforcing its frequent-trading policies. The rule also limits the information-sharing requirement to so-called first-tier intermediaries that submit orders directly to mutual funds or route them through their principal underwriters and transfer agents or a clearing agency.

The SEC also clarified penalties: A fund must bar intermediaries that refuse to strike information-sharing agreements from purchasing its securities.

Tough love, perhaps, but a number of industry observers question the new rulemaking. If Rule 22c-2 reduces abusive trading, they say, it may be for reasons unforeseen by the SEC. Advances in fair-value pricing have enabled mutual funds to reduce disparities between their funds' net asset values and the underlying securities they hold, especially those listed on foreign markets. That reduces arbitrage opportunities and undercuts the need for short-term redemption fees to discourage abusive traders. Meanwhile, the dramatic decline in the cost of trading, accompanied by advances in information processing, means that plan sponsors have new options for avoiding burdensome and costly information-sharing arrangements. More plan sponsors may simply opt out of mutual funds in favor of less-regulated institutional investment vehicles known as collective trusts.

"It is a classic case of the regulators fighting last year's war," says Burton Greenwald, president of B.J. Greenwald & Associates, a financial services consulting firm based in Philadelphia.

Redemption fees appear to be a case in point. Fund companies have typically waived these fees for defined-contribution-plan participants, who generally pour money into their plans from every paycheck -- and whose frequent but legitimate purchases and sales could run afoul of such rules. Although the SEC provision doesn't mandate redemption fees, Larry Goldbrum, general counsel for Spark Institute, a retirement industry trade group in Simsbury, Connecticut, argues that the agency has implicitly endorsed such fees as its preferred method for controlling abusive trading. The SEC's Plaze disagrees with that contention; he points out that Rule 22c-2 explicitly acknowledges that redemption fees are just one of several methods that funds can use to discourage market timing. Nonetheless, Spark and other industry trade groups lobbied the SEC -- unsuccessfully -- to establish uniform terms and conditions for redemption fees and to mandate an exemption for automatic contributions.

With the ink barely dry on the SEC's new rule, some fund companies are deemphasizing redemption fees. In October, Boston-based Putnam Investments announced that it would reduce its fees from 2 percent to 1 percent. In December, State Street Global Advisors and Massachusetts Financial Services, both also based in Boston, announced that they would completely eliminate redemption fees on their funds.

"We simply do not believe that redemption fees were the only tool to prevent trading abuses, and certainly not the most effective tool in isolation," says Gordon Forrester, head of mutual fund marketing at Putnam.

Instead, these firms plan to monitor trading patterns and rely on fair-value accounting to reduce the arbitrage opportunities that result from pricing disjunctions between their mutual funds' net asset values and the underlying securities they hold. Interactive Data Corp.'s FT Interactive Data, Investment Technology Group and Standard & Poor's are among the leading purveyors of systems that enable fund companies to reprice their foreign securities at the close of the U.S. markets based on movements in a domestic benchmark like the S&P 500 index or the Russell 1000 index. The technology that computes the appropriate correlations has advanced substantially in recent years.

"Five years ago the trigger for repricing would have been a move of 150 basis points by the S&P 500," says Paul Kraft, deputy national director of investment management services at accounting and consulting firm Deloitte & Touche. "Now we are down to triggers of zero to 25 basis points."

In a 2006 Deloitte survey of 77 money managers with a combined $3 trillion in assets, 84 percent were using fair-value pricing for their foreign equities exposure and 33 percent were using it for domestic fixed-income products. The vast majority of managers reported a decrease in market-timing activity after implementing their fair-value-pricing procedures.

The impact of the SEC's rulemaking extends beyond the issue of redemption fees. Declining trading costs and advances in information technology have already weakened the case for aggregated trading in omnibus accounts. The new mandate for information-sharing agreements could tip the scale even further and encourage more intermediaries to forward their trades to mutual fund firms on an unaggregated basis. This approach, called long-title registration, obviates the need for such agreements.

"Our customers are weighing [trading costs] against the cost of compliance with regulations such as the SEC's Rule 22c-2," says John Moody, president of Matrix Settlement & Clearance Services, a Denver-based transfer agent that clears trades for $65 billion in mutual fund assets and provides custody and transfer agent services to 140 third-party retirement plan administrators that oversee roughly $26 billion in assets.

Matrix's customers include 14 bank trust departments that are trading securities on a long-title-registration basis. On the qualified-retirement-plan side of the company's business, an additional ten banks are bypassing at least one level of omnibus aggregation, and the firm anticipates that more intermediaries will follow suit. "We expect to have at least 28 bank trusts using long title by next year, given the current state of our conversations," says James de Rubertis, Matrix's national sales manager.

More plan sponsors may simply opt out of mutual funds altogether. "Several of our plan sponsor clients have expressed enough dissatisfaction with mutual funds -- and specifically the regulatory requirements of redemption fees and frequent trading policies -- that they are turning to collective funds and other options that don't have all those hoops," says Daniel Esch, founder and managing director of Defined Contribution Advisors, a Minneapolis-based retirement plan consulting firm.

Institutional investment vehicles in defined contribution plans, which include collective trusts and separately managed accounts, represented 34 percent of total assets in 2003, up from 30 percent in 1998. That figure is expected to climb to 44.5 percent by 2008, according to Cerulli Associates.

Evaluating collective trust investments is getting easier too. Beginning this month, Morningstar, the Chicago-based mutual fund research firm, will enhance its coverage by publishing net returns on approximately 650 such vehicles. Morningstar will also provide monthly rankings and award its star ratings, making it easier to compare collective trusts with retail mutual funds.

"We've had substantial interest from large plan sponsors and their providers," reports John Rekenthaler, vice president of research at Morningstar.

If that interest intensifies, ironically, new regulation could be in the offing.