An Ontario Court judge has ruled two Canadian mutual fund companies acted negligently by allowing big investors to make improper trades in some of their funds. The victims are the small investors in the funds who had no idea it was happening.
 
CI Mutual Funds Inc. and AIC Limited (now AIC Global Holdings Inc.) will face another trial to determine damages, which the counsel for the plaintiffs in the 17-year-old class-action lawsuit say could total as much as $674-million.
 
The ruling stems from a 2003 Ontario Securities Commission investigation involving five Canadian financial services companies. All five, including IG Investment Management Ltd., Franklin Templeton Investments Corp., and AGF Funds Inc., have already paid over $200-million in settlements to unit-holders.
 
The practice deemed improper is called “market timing.” It permits large investors - for a fee - to trade investments inside a fund quickly. Market timing is most common in foreign equity funds with holdings that trade overseas because their prices are usually locked in from the end of the North American trading day until trading resumes the following day. That gives market timers a huge window of opportunity to cash in while returns for long-term unit holders are diluted.
 
It’s like taking your car for servicing and having the mechanic rent it out to other drivers without your knowledge while you wait. They get the extra cash and you pay for the wear-and-tear, and run the risk if things go horribly wrong.
 
In this case, the victims are investors who held money in those funds between 1998 and 2004. The court found large volume, short-term trades in the funds amounted to hundreds of millions of dollars per month.
 
And there’s no assurance it hasn’t happened since or isn’t happening now, which brings up the larger issue of transparency in mutual funds. Most Canadians invest in mutual funds for retirement because it’s the only choice for those with modest portfolios who want professional management and diversification.
 
In terms of holdings, mutual funds are not required to disclose a heck of a lot. A few top holdings are normally listed on the company website but there are no regulatory requirements to list them all or keep them updated. The fund you think you’re invested in might not be that fund at all.
 
The lack of transparency helps explain why so many Canadian retail investors have been flocking to exchange traded funds. A basic market-weighted ETF tracks basic market-weighted indices. 

That means an ETF that tracks the S&P 500, for example, invests in S&P 500 listed companies according to their current market value. Weightings in Apple or Microsoft are adjusted in the ETF within hours as their market values fluctuate. 
 
Determining how much of any company is in a market-weighted ETF at any time is as simple as calling up the index.
 
Another reason for the flight to ETFs are annual fees that are a fraction of mutual fund fees, which leaves more of an investment invested. 
 
The downside to ETFs is a lack of professional management. There’s no one at the helm to avoid troubled waters or implement a strategy suitable to an individual investor’s goals or tolerance for risk.
 
Many mutual funds outperform their benchmark indices consistently but most underperform due to fees that are often over 2.5 per cent annually. With so little information other than past performance, finding the best mutual funds is difficult.
 
In many cases, top holdings in a mutual fund are curiously similar to the top holdings in their benchmark indices. The term for that is “closet indexers” and they will remain in the closet until mutual funds are required to provide more timely details on what’s in their funds.