Controlling hot money

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________________________________________________________________________________________________________________________________ Senior Lecturer Robert C. Pozen prepared this case. The company and characters mentioned in the case are fictional. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2010, 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

R O B E R T C . P O Z E N

Controlling Hot Money

As Sofia Herrara turned the pages of the binder of materials prepared for the board of directors of the Japanese Equities Fund, she was pleased by the work her team had done. Herrara was the chief financial officer of Global Management Company (“Global”), the investment manager of the Japanese Equities Fund. Herrara was preparing to brief the board at its next meeting on September 15, 1997, on one of the thorniest issues the Japanese Equities Fund had encountered in recent years. David Smith, the portfolio manager of the Japanese Equities Fund, had alerted Herrara several weeks ago about his concerns over the fund’s cash flow volatility. Herrara and her team had worked diligently since then to analyze the issues Smith had raised.

Smith had reported that since the beginning of 1997, the U.S.-sold Japanese Equities Fund had experienced substantial cash inflows and outflows from investors. He also noted that extremely large shareholder orders seemed to coincide more and more with news affecting Japan. Smith suspected that perhaps some shareholders were trying to increase their profits by “timing” the market—quickly moving their money from one fund to another within the complex. Furthermore, these investors might be attempting to profit from the methodology that the fund complex used to compute the daily net asset value (NAV) of the fund by trading on stock price information that might become available between the time when Japanese markets closed and the time when the Japanese Equities Fund valued its holdings.

Smith found that cash flow management was taking up a large percentage of his time that he might otherwise have spent selecting securities, and portfolio transactions had increased greatly as a result of the volatile cash flows. Smith was concerned that increased shareholder activity was leading to higher fund expenses. Smith had asked Herrara to look into the shareholder activity and analyze whether the pricing of the fund had encouraged or contributed to the cash flow volatility.

It quickly became clear from Herrara’s inquiry into the issues Smith raised that the independent directors of the Japanese Equities Fund would need to be apprised of the matter. Herrara and the CEO of Global, Harry Cutler, were the two members of the Japanese Equities Fund’s board who were affiliated with the fund. The remaining eight board members were independent directors. If the actions of a particular set of shareholders were resulting in increased fund expenses and volatile cash flows, the board would need to examine the facts and solve the dilemma. Herrara closed the binder and began to outline her presentation to the board.

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Background on the Japanese Equities Fund

Introduced on October 28, 1993, the Japanese Equities Fund was a non-diversified, SEC-registered mutual fund. The fund’s fundamental investment objective was to achieve long-term growth primarily through investment in securities of Japanese companies. The fund could hold any type of equity or debt securities, although equity securities were normally expected to account for the majority of the fund’s investments. The Japanese Equities Fund could also invest in indexed and debt-like securities whose value depended on the price of foreign currencies, securities indexes, other financial indicators, or underlying interests. As of August 31, 1997, the fund had assets of $125 million and 12,500 shareholders with an average account size of $10,000.

In addition to managing the Japanese Equities Fund, Global also served as manager of the other mutual funds in the Global complex: Emerging Growth, Large-Cap Stock, Small-Cap Stock, S&P 500 Index, Diversified International, Emerging Markets, Europe, Latin America, and High Income Bond. Shareholders of any fund in the Global complex could sell their fund shares and buy shares in other Global funds, subject to any restrictions detailed in each prospectus.

Regional international funds, which were relatively new offerings for Global, seemed to have gained in popularity. Assets in the funds had increased at a fairly steady pace the prior year, and the complex now had a few funds (mentioned above) that focused on a non-U.S. region or country. Although these focused funds carried higher risk than diversified international funds, they had the potential for higher returns. Because they were more concentrated than diversified international funds, country funds appealed to investors who wanted to take more personal control of their investments, potentially including more active traders. As a result, Global anticipated that the Japanese Equities Fund might experience higher shareholder volatility, but the recent wave of cash that had been moving in and out of the Japanese Equities Fund seemed to be especially high.

Fund Operating Expenses

Certain fund operating expenses for Global’s international funds were higher than for the domestic funds, taking into account the difficulties of managing securities of foreign issuers (see Table A). To compensate Global for its investment advisory services, the Japanese Equities Fund paid an annual investment management fee to Global equal to 0.80% (or 80 basis points) of the fund’s daily net assets; by contrast, the management fee for Global’s S&P 500 Index Fund was 0.10%.

Table A Annual Fund Operating Expenses

Source: Casewriter.

The “other expenses” of the Japanese Equities Fund, which included expenses paid to the fund’s custodian, lawyers, accountants, and its transfer agent, were 0.52%—also higher than for domestic funds. (Exhibit 1 gives additional details on the significant “other expenses” of the Japanese Equities

Management fee 0.80%

12b-1 fee 0.25%

Other expenses 0.52%

Total fund operating expenses 1.57%

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Fund.) The fee schedule for both the transfer agent and the custodian for the Japanese Equities Fund included a flat fee plus a fee for each transaction. The transfer agent for the fund, which processed all purchases, redemptions, exchanges, and distributions for the fund, provided shareholder account information and handled shareholder questions and problems, charged a flat fee equal to $10 per account, as well as a fee of $12 for each transaction the transfer agent processed. Thus, in addition to the flat fee of $10 the Japanese Equities Fund paid to its transfer agent for every shareholder account in the fund, each shareholder purchase or redemption of shares cost the fund $12.

The custodian for the Japanese Equities Fund, which held all of the portfolio securities of the fund in segregated accounts and accounted for the cash payments and receipts generated by purchases and sales of the portfolio securities in the fund, was paid an annual charge of 0.02% of average assets, as well as a transaction fee of $40. In other words, each time a portfolio security of the Japanese Equities Fund was bought or sold, the fund paid the custodian a $40 transaction fee.

Finally, the 12b-1 fees that compensated the fund distributor for marketing and selling fund shares were 0.25%.

The Trading Desk

Once a portfolio manager decided to buy or sell a portfolio security, it was the job of the fund’s trader to execute the buy or sell order. Most larger investment managers had a trading division or “desk” that was separate from the portfolio management function. This division of labor allowed the portfolio manager to concentrate on selecting securities and structuring the portfolio, while the traders focused on the dynamics of the market to judge the appropriate time to complete a buy or sell order. The timing of completing a buy or sell order was part of seeking the “best execution”—the objective of completing a transaction so that the total cost was most favorable to the fund under the particular circumstances at the time. The cost of completing a buy or sell order included: commissions, fees, and taxes; market impact; and currency costs. Market impact referred to the effect that trading an asset might have on the price for the asset. Market impact depended upon the order size, the market liquidity for the security traded, and the time in which the fund wanted to complete the trade. A fund might push the price of a security up when buying or down when selling a large block of thinly traded portfolio securities within a short period of time.

International funds incurred currency costs since they were priced in U.S. dollars and held U.S. cash, but traded in foreign securities. For example, when the Japanese Equities Fund wanted to buy Japanese securities, it had to first buy yen with dollars. The bid/ask spread on currency trades for the Japanese Equities Fund was 10 basis points. (Exhibit 2 shows the commission, market impact, and currency costs for a one-way trade for the Japanese Equities Fund.) The average equity trade for the fund was 2,500 shares at $40 per share.

Short-Term Trading

Global had found that short-term trading was somewhat more likely to occur in aggressive or volatile funds, or funds that were concentrated in one type of investment. Investors who were looking to place a short-term “bet” would have more difficulty doing it in a diversified fund, where the manager had more discretion to move money among asset market sectors and possibly asset classes. Since most sector and country funds had relatively small shareholder bases, a few shareholders making short-term trades could cause huge cash flow volatility relative to the size of the fund.

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Short-term trades affected various categories of the fund expenses that were paid by all shareholders in the fund. Brokerage commissions were not reported as part of a fund’s operating expenses. Instead, they were accounted for as an addition to the cost basis, or a reduction in the proceeds from the sale, of the fund’s portfolio securities and therefore reduced the capital gains (or increased the loss) realized by the fund.

Sales Loads Paid by Shareholders

The Japanese Equities Fund was sold with a 5% front-end sales load. (See Exhibit 3 for sales loads paid by Japanese Equities Fund shareholders.) Front-end sales loads were a sales commission charged by some fund complexes when an investor purchased mutual fund shares. Back-end loads, on the other hand, were a sales commission levied by some load funds when an investor sold mutual fund shares. These back-end loads typically were structured as a contingent deferred sales charge (CDSC), which often started at 5% or 6% of money withdrawn within a year of buying the fund and then declined by a percentage point or so each year until the fee disappeared. Back-end loads were paid to the fund distributor to recoup sales commissions that the distributor advanced to intermediaries selling fund shares if the shareholder left the fund before it paid sufficient 12b-1 fees to the distributor.

Like most other mutual fund complexes, Global granted investors the privilege of exchanging in and out of funds within the complex and also allowed credit for any load paid when purchasing or redeeming one of the funds. For the purpose of calculating an applicable CDSC of Fund X, almost all complexes also gave credit to investors for the holding period of shares purchased in other funds of the same complex if those shares were exchanged into Fund X. For example, if an investor paid a 5% front-end load to buy the Putnam Japanese Equities Fund and within a month exchanged to Fund X, which was in the same complex and also carried a 5% front-end load, the investor would not pay a second sales load. The investor also would not pay any CDSC to the Japanese Equities Fund since the one month the investor spent in the fund would be added to the time the investor spent in Fund X for the purpose of a CDSC. Each fund reserved the right to terminate or modify the exchange privilege at any time in the future.

Redemption Fees

Redemption fees were defined as fees paid to the fund (as opposed to loads, which were paid to the distributor). They were often imposed on shares redeemed within a relatively brief period (e.g., 90 days); they were sometimes used to dissuade short-term trading and/or to compensate the remaining shareholders for the adverse effects of such trading. Redemption fees typically were charged on exchanges into other funds within the complex, as well as account liquidations (i.e., leaving the complex). Some funds were introduced with redemption fees initially, while others had redemption fees added after experiencing heavy cash flow volatility.

Global previously had determined that the level of a redemption fee should be based on the trading costs associated with the type of portfolio and had used estimates of turnover costs, including such factors as commissions, taxes, and bid-offer spreads. The company felt that redemption fees based on a holding period were clear-cut and precise, but such fees might affect people who sold after a short period even though they did not buy the fund with the intent to make a short-term or market-timing investment.

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General Mutual Fund Pricing

Most mutual funds sold in the United States were priced daily at 4 p.m. ET to correspond to the closing of the New York Stock Exchange (NYSE), although the time of pricing was left to the board of directors of each fund. Since there was no secondary market in fund shares, a daily price meant that investors could be assured of having their orders executed within 24 hours (during normal business days). Although more frequent valuations were allowed, they might be prohibitively expensive for a fund manager, from both an administrative and an operational perspective.