[18098]
October 14, 2004
TO: BOARD OF GOVERNORS No. 65-04
INDEPENDENT DIRECTORS COUNCIL No. 9-04
RE: STUDY COMMISSIONED BY THE INSTITUTE ON SOLUTIONS TO THE MARKET
TIMING PROBLEM
The attachment is a study commissioned by the Institute concerning remedies to the problem of
market timing that was discussed at the Board of Governors Meeting on Friday, October 8. The
study is entitled On Solutions to the Mutual Fund Timing Problem and was authored by Gregory
Bryant Kadlec, Pamplin Professor of Finance at Virginia Polytechnic Institute.
Drawing upon published research, Professor Kadlec concludes that fair valuation and other
trading frictions (such as redemption fees or trading restrictions) are necessary to stop market
timing in mutual funds. He notes that market timing stems from the predictability of net asset
values. This predictability can arise from the use of stale prices to value securities and from
other sources that are inherent in the determination of securities prices. In line with SEC
guidelines, fair valuation of portfolio securities only involves the removal of staleness; it does
not, and should not, eliminate other sources of predictability. In the absence of trading frictions,
as Professor Kadlec observes, market timers and arbitrageurs can exploit the predictability in
net asset values that persists even after fair valuation. Thus, trading frictions are essential to a
comprehensive solution to market timing.
In light of the Commission’s ongoing consideration of proposed rules designed to curb the
potential for market timing of fund shares, the Kadlec study is important and timely. We have
shared it with the Commission and other interested parties.
John D. Rea
Vice President - Research
Chief Economist
Attachment (in .pdf format)