On the Fritz

martin fridson

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Timing, long recognized as an essential skill for stand-up comics, has not been a laughing matter among investors lately. For starters, market timers fueled a $3.3 billion cash inflow to high-yield bond mutual funds in the next-to-last week of August. That beat the previous all-time record by an alarming $1.7 billion. Then, on September 3, market-timing burst into the headlines as New York State Attorney General Eliot Spitzer launched a crackdown on questionable trading of mutual fund shares.

Spitzer’s most sensational allegations involved much more than garden-variety market timing. He accused Canary Capital Partners of after-hours trading in mutual fund shares, a practice he likened to betting on yesterday’s horse races. At the same time, the attorney general criticized short-term “in-and-out” trading of fund shares by Canary and other aggressive players.

Nor were Spitzer’s revelations limited to the equity world: speculative-grade bonds also made a cameo appearance. According to Spitzer, Janus Capital granted Canary permission to time its high-yield fund. The relevant prospectus, however, stated that the fund was “not intended for market timing or excessive trading”.

Spitzer’s mention of market timing in high-yield funds drew attention to a phenomenon that while not new, has been growing in importance. In August 2003, the timers’ fingerprints could be found not only on the biggest one-week high-yield mutual fund inflow of all time, noted above, but also the biggest one-week outflow. Normalizing for growth over time in the funds’ assets, nine of the 20 largest flows (positive or negative) since 1992 have occurred since the beginning of 2002.

The gargantuan scale of August’s swings in mutual fund flows could not be explained by short-run changes in the high-yield sector’s fundamental outlook. Neither did it appear that income-oriented small investors were jumping in and out of the funds with unprecedented frequency. Rather, the heightened volatility reflected increasingly large market timing activity by professional speculators. As in the past, the timers geared their frenetic trading to momentum models, rather than underlying credit factors.

In principle, there is nothing wrong with timing the market in high-yield bonds. By injecting capital at low points and withdrawing it when prices rise too high, speculators can help to keep the sector within its appropriate valuation range. The ultimate effect should be to promote efficient allocation of capital.

Speculative-grade bond investors would be closer to this utopian state if a deep, liquid market in speculative-grade bond index rate swaps existed. Unfortunately, the high-yield derivatives market is severely underdeveloped. JP Morgan Chase’s Hydi product has partially filled the previous void, but open-end mutual funds remain the primary vehicle for high-yield market timers.

Unfortunately, using high-yield mutual funds for market timing has a serious drawback. Severe shocks occasionally push down high-yield bond prices more rapidly than fund managers can mark down the asset value (NAV), despite their best efforts. Timers exploit this vulnerability by cashing in their shares at temporarily overstated NAVs. The excess payouts represent losses for investors who remain in the fund.

Someday, perhaps, in-and-out trading of high-yield market baskets will migrate from mutual funds to better-suited derivatives. At that point, long-term holders may look back and laugh at the present overshadowing of market timing’s theoretical benefits by execution-related difficulties. In the meantime, though, timing will remain a matter of mirth only to patrons of comedy clubs.

Martin Fridson is a veteran of high-yield analysis and founder of FridsonVision, a high-yield research firm (www.leverageworld.com).
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