The practice of market timing is taboo in the mutual-fund business, especially now that timing abuses have come to light and regulators are trying to end them. At several small fund firms, however, market timing is a legitimate business model, if not a virtue.
Although they are niche players in the $7 trillion fund business, funds that cater to active traders -- Rydex Global Advisors, ProFund Advisors, and The Potomac Funds -- are gaining in popularity. ProFund's assets have increased 20% since the fund scandal broke in September. The others are also reporting brisk inflows, which are likely to continue as regulators move to slap redemption fees on most funds. (Money-market and market-timing funds are expected to be exempt.)
The allure of these fund groups is that there are no restrictions on how often an investor can buy and sell fund shares. You can buy a fund on Monday and sell it on a Tuesday and buy it back again on Wednesday. Most firms have limits on the number of trades an investor can make annually. In nearly all the mutual funds at Vanguard Group, for example, you can make only two round-trip trades (buy and sell the same fund) each year. Although some large fund companies have clearly violated the rules, others strictly enforce them. American Century Investments has eight people whose job is to comb investors' trading records looking for timers. Violators may be asked to leave if they don't follow the rules.
Most of the market-timing funds are also index funds. That makes it easier for the managers to trade the underlying securities in response to rapidly changing inflows and outflows. With indexing, managers also can more easily use derivatives to enhance performance.
TURBOCHARGED -- AND VOLATILE
Even if they are mainly based on indexes, timer funds aren't as cheap as a plain-vanilla Standard & Poor's 500-stock index portfolio. True, they don't levy sales charges or redemption fees, but they do carry a premium for trading privileges. Expenses average above 1.60% of assets at Potomac and Rydex and 2.09% at ProFund. That's high for index funds, but not for more conventional funds run by stockpickers.
Of course, many investors will pay a premium for innovative funds that you just don't find anywhere. Sure, you can buy simple S&P 500 funds, but you can also choose turbocharged funds that seek to magnify the daily performance of major indexes such as the NASDAQ 100. That's the point of Potomac OTC Plus (POTCX), Potomac's best-performing fund. These companies offer funds that move in the opposite direction of the market by selling short securities or derivatives. Those were great performers during the bear market, but they're not doing well now, except for those that are bearish on bonds -- such as ProFund Rising Rates Opportunity (RRPIX) and Rydex Juno (RYJUX).
These funds -- especially the souped-up versions -- can be extremely volatile. Case in point: Potomac OTC Plus gained more than 129% in 1999, but it dropped nearly 48% the following year. That volatility, however, is what market timers savor. "If you are adept enough to pick [funds] at the right time, you can make money in any market," says James Ackles, president, CEO, and CIO of LBS Capital Management in Clearwater, Fla., who times the market.
After three straight years of losses in equities, timing is gaining some credibility over the buy-and-hold style. It doesn't hurt that experts, including investment guru Peter Bernstein, say active trading could be the best way to make money in coming years because trends will be shorter-lived and the market more volatile. "This whole concept that 'buy and hold' is safe is extremely misleading to the public," says Roger Schreiner, an Exton, Pa., adviser who practices market timing. "You have to accommodate weather and traffic conditions."
Market timing sounds easier than it is. "The reason we caution investors about market timing is that so many have tried it -- and so many have failed," says Jeffrey Ptak, an analyst at Morningstar, the Chicago fund tracker. The strategy requires tremendous rigor and a laser focus on the ever-changing markets. Most investors simply don't have that kind of discipline, and these companies want just the serious traders. Rydex, for instance, sets the bar high by requiring a $25,000 minimum initial investment, though investors can get in with lower minimums by using a fund supermarket. Nearly three-quarters of Rydex' clients are financial advisers.
Truth be told, many market timers don't trade all that much. Rydex reports just 20% of its customers trade in and out of a fund more than once a month. Maybe they spend the rest of the time deciding when to make those trades. By Lauren Young