NEW YORK (CNN/Money) - Some big mutual fund firms may be on the hook for allegedly allowing a hedge fund firm to practice market timing and "late trading" strategies. And that's got you wondering, "So, how is it that I may have lost money?"
Put simply, when a trader invests in a fund for a brief period of time, it's like he's the uninvited guest at a pizza party. When he eats and runs, that means there's less to go around for everyone else left behind.
Bottom line: "The (individual investor's) slices aren't as big," said Conrad Ciccotello, an associate professor of risk management at Georgia State University.
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Market timing in this context indicates a trader who invests in a mutual fund for sometimes as little as a day to profit from inefficient pricing. Late trading, an illegal activity, is a similar strategy with one exception. Trades are placed after the market close yet the trader gets to buy in at that day's net asset value (NAV) per share. Generally, orders placed after the close of trade are supposed to be valued at the next day's NAV.
A complaint filed Wednesday against the hedge fund firm Canary Capital Partners by the state of New York cited one study that estimates that market timers cost mutual funds and their investors $4 billion a year. There are no studies measuring the financial impact of late trading, but the way in which it might influence investor return is similar to that of market timing.
Here's one example, from Yale professor of finance K. Geert Rouwenhorst, on how market timing and late trading can take money out of your pocket:
Say a mutual fund investing in European stocks has four long-term shareholders who each own one share. The fund's net asset value per share (set once a day at the close of trade in New York) is $10 on Monday. So the total value of the fund is $40 ($10 per share x 4 shareholders).
At 2 p.m. ET Monday, good news about various holdings in the fund comes out, news that is likely to push share prices higher by 25 percent when trading resumes in Europe Tuesday. But your fund's NAV Monday doesn't yet reflect this good news because it's based on share prices at the close of European trade, which occurs several hours before Wall Street shuts down.
The fund's shareholders might expect their NAV to rise 25 percent on Tuesday to $12.50 a share. Then the fund's total value would be $50 ($12.50 per share x 4 shareholders).
But they'll get less if a market timer or late trader steps in.
Here's how: Say the trader senses prices will go up and decides to buy a share of the fund at Monday's NAV of $10.
Tuesday rolls around, and sure enough European prices rise and so does the fund's NAV. With the trader's late-day investment Monday plus the boost in share price, the fund's total value comes to $60 ($50 after 25 percent rise in share price + $10 cash investment from the trader).
With the trader, there are now five shareholders in the fund, so each fund share is now worth $12 ($60/5), instead of the $12.50 the four original shareholders were expecting.
The trader will sell his share on Tuesday for $12, booking a $2 profit. That's the equivalent of 50 cents a shareholder – which is the same amount forfeited by each of the original shareholders because of the trader's actions.
In other words, instead of getting the 25 percent increase in NAV they were expecting, the shareholders only see a 20 percent increase.