Posted on May 15, 2014 | Investor Update
T. Rowe Price blocked approximately 1,300 American Airlines employees from trading into their retirement plan mutual funds over the past three years due to excessive activity, according to Money Magazine. Some of the airline’s employees received lifetime bans. Southwest Airlines employees have also been warned by Vanguard to end their trading, according to Money.
Those of you who subscribe to Money may have seen the article. It’s not the first one on the subject and likely won’t be last. Though most mutual funds reserve the right to ban an investor from buying and selling its funds, it is rarely used. Investors who do get banned have frequently traded in and out of mutual funds, commonly on the guidance of a newsletter or an adviser.
It is my understanding that in order to get banned, or even to get a warning letter, a large amount of short-term trading has to occur. What prompts the warnings and the bans can often be a group of investors acting in unison, often on the recommendation of a central party (e.g., an advisory service). If enough shareholders move to buy or sell at the same time, the mutual fund could end up with more cash inflows or outflows then it is prepared to handle.
Understanding the structure of mutual funds is key to understanding why investors who trade too frequently can be banned. A mutual fund pools shareholder dollars together to buy and sell securities. It may be helpful to visualize a mutual fund as a group bucket of shareholder dollars. The fund manager, in turn, uses the cash in the bucket to buy various securities on behalf of the shareholders—while taking a small amount out of the bucket for the fund’s fees. When shares of the mutual fund are bought by an investor, new dollars are put into the bucket. When shares of the mutual fund are sold by an investor, money comes out of the bucket.
Mutual fund managers always keep a small amount of cash in the bucket to facilitate typical deposits and withdrawals by shareholders. Problems occur when the flow of cash into or out of the bucket is greater than usual. Such occurrences can give the fund manager more excess cash to work with than he planned on, or, in the case of withdrawals, can cause the fund manager to sell more securities than he would like to at a particular point in time. This is why mutual fund companies take steps to discourage too-frequent trading and ban those who ignore warnings to stop.