Report to the Subcommittee on 

Oversight, Committee on Ways and 

Means, House of Representatives 

United States General Accounting Office 

GAO

July 2004 MUTUAL FUNDS

SEC Should Modify 

Proposed Regulations 

to Address Some 

Pension Plan 

Concerns 

GAO-04-799 
www.gao.gov/cgi-bin/getrpt?GAO-04-799.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Barbara 

Bovbjerg at (202) 512-7215 or 

bovbjerg@gao.gov. 

Highlights of GAO-04-799, a report to the 

Subcommittee on Oversight, Committee 

on Ways and Means, House of 

Representatives 

July 2004

MUTUAL FUNDS

SEC Should Modify Proposed 

Regulations to Address Some Pension 

Plan Concerns 

The cost of late trading and market timing to long-term investors in mutual 

funds is unclear; however, it does not appear that these abuses affected 

pension plan participants more than other investors. While individual 

instances of abusive trading may not have had a noticeable effect on the 

value of funds held by long-term investors, the cumulative effect of such 

trading may be significant. Among 34 brokerage firms surveyed by the SEC, 

more than 25 percent reported instances of illegal late trading at their firms. 

However, numerous fund intermediaries that are not regulated by the SEC 

may also have permitted late trading. Trading abuses can be difficult to 

identify because, among other reasons, fund brokers aggregate the 

transactions of their clients and often do not share details of individual 

transactions with mutual fund companies. Ultimately, the effect of trading 

abuses on the savings of plan participants and other long-term fund 

shareholders is a function of which funds they invested in and for how long. 

SEC and DOL have taken steps to address abusive trading in mutual funds, 

and SEC has proposed regulations that aim to stop late trading and curb 

market timing. SEC and DOL are investigating these trading abuses, and SEC 

has already reached several settlements. DOL has issued guidance to 

pension plan sponsors and other plan fiduciaries on how they can fulfill their 

legal requirements to act “prudently” and in the best interests of plan 

participants who invest in mutual funds. To stop late trading, SEC has 

proposed that all fund transactions be received by mutual funds or 

designated processors before 4:00 p.m. eastern time in order for investors to 

receive the same day’s price. To curb short-term trading, including market 

timing, SEC has proposed regulations that would impose a 2-percent fee on 

the proceeds of fund shares redeemed within 5 business days of purchase. 

DOL is not involved in the process of drafting these regulations because it 

does not regulate mutual funds, but it is considering how the proposals 

would affect pension plans. 

To the extent that SEC’s proposed regulations stop late trading and market 

timing, they would benefit long-term mutual fund investors; however, the 

new rules could also affect such investors adversely, and pension plan 

participants more than others. The new regulations are expected to increase 

costs (e.g., for technology upgrades) that would be passed on to long-term 

mutual fund investors. In addition, plan participants could be distinctly 

affected by the late trading proposal because it creates potential 

complications in processing certain transactions unique to pension plans 

(e.g., loans). Further, the market timing proposal may result in plan 

participants paying fees intended to deter market timing, even when there is 

clearly no intent to engage in abusive trading. SEC officials told us that they 

are considering changes and alternatives to the proposed regulations that 

would address these concerns.

Mutual fund investments represent 

more than 20 percent of Americans’ 

pension plan assets. Since late 

2003, two abusive trading practices 

in mutual funds have come to light. 

Late trading allowed some 

investors to illegally place orders 

for funds after the close of trading. 

Market timing allowed some 

investors to take advantage of 

temporary disparities between the 

value of a fund and the value of its 

underlying assets despite stated 

policies against such trading. The 

Securities and Exchange 

Commission (SEC) has proposed 

regulations intended to stop late 

trading and reduce market timing. 

We were asked to (1) report on 

what is known about how these 

practices have affected the value of 

retirement savings of pension plan 

participants, (2) describe the 

actions taken by SEC and the 

Department of Labor (DOL) to 

address these practices, and 

(3) explain how plan participants 

may be affected by SEC’s proposed 

regulations. 

GAO recommends that the SEC 

Commissioners adopt 

modifications or alternatives to the 

proposed regulations that would 

prevent pension plan participants 

from being more adversely affected 

than other investors. 

In its response to GAO’s draft 

report, SEC agreed with GAO’s 

analysis and noted that it is 

considering modifications to the 

proposed regulations. 
Page i GAO-04-799 Mutual Funds 

Letter 1

Results in Brief 4

Background 6

Mutual Fund Trading Abuses Affected Pension Plan Participants 

but the Extent Is Unclear 11

Regulators Are Taking Actions to Address Abusive Mutual Fund 

Trading 18

Most Plan Participants Could Benefit from SEC’s Proposed 

Regulations but Face Greater Costs than Other Investors 22

Conclusions 30

Recommendations for Executive Action 31

Agency Comments 31

Appendix I Objectives, Scope, and Methodology 32 

Appendix II Alternative Proposals to Eliminate Late Trading 34 

Appendix III Comments from the Securities and Exchange 

Commission 37 

Figures 

Figure 1: Path of Mutual Fund Transactions 9

Figure 2: Comparison of Fund Net Asset Value with and without 

Market Timing 13

Figure 3: Mutual Fund Defined Contribution Plan Assets by Type of 

Fund 17

Figure 4: Potential Complication with Loan Transaction if Dollar 

Amount Is Specified 27

Figure 5: Potential Complication with Loan Transaction if Number 

of Shares Is Specified 28

Figure 6: Assessment of a Redemption Fee for an Exchange 

Transaction 30

Contents 
Page ii GAO-04-799 Mutual Funds 

Abbreviations

DOL Department of Labor 

ERISA Employee Retirement Income Security Act of 1974 

NSCC National Securities Clearing Corporation 

OCC Office of the Comptroller of the Currency 

SEC Securities and Exchange Commission 

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reproduce this material separately. 
Page 1 GAO-04-799 Mutual Funds 

July 9, 2004 

The Honorable Amo Houghton, 

Chairman 

The Honorable Earl Pomeroy 

Ranking Minority Member 

Subcommittee on Oversight 

Committee on Ways and Means 

House of Representatives 

Mutual funds represent a significant portion of Americans’ retirement 

wealth, with 21 percent of the more than $10 trillion in pension plan assets 

now invested in mutual funds. These funds are particularly popular in 

defined contribution plans,1

 because they allow investors to pool their 

savings with those of other investors so that they may benefit from 

professional investment management and diversification, among other 

things. Most defined contribution plan assets in mutual funds are allocated 

to funds that invest in America’s equity markets and thus serve as an 

important source of capital for investment in the economy. Furthermore, 

while broad stock market indexes fell 22 percent in 2002, continuing 

contributions into defined contribution plans sustained some of the 

demand for stocks and may have helped prevent even greater declines in 

their value. 

In September 2003, the New York State Attorney General alleged that 

some mutual fund companies had allowed some investors to engage in 

abusive trading practices that hurt the savings of long-term investors, 

including pension plan participants. Several investors and mutual fund 

companies have since settled their cases with both federal and state 

authorities. One type of abusive trading, known as “late trading,” allows 

certain investors to submit orders illegally for fund transactions after the 

close of the financial markets in New York (when mutual funds usually 

calculate their share prices) and still receive the same day’s price per fund 

 1

Defined contribution plans are one type of employer-sponsored pension plan. Employee 

benefits are based on employer and/or employee contributions and investment returns 

(gains and losses) on individual accounts. Employees bear the investment risk and often 

control, at least in part, how their individual account assets are invested. According to the 

most recent Department of Labor information, most private-sector pension-covered 

workers in the United States are covered only by defined contribution plans. 

United States General Accounting Office 

Washington, DC 20548 
Page 2 GAO-04-799 Mutual Funds 

share.2 Late traders were able to purchase or redeem (sell back to the 

fund) shares in reaction to news, such as corporate earnings 

announcements, that were released after the markets closed. Such news 

would often affect the next day’s closing prices of fund shares, and thus 

late traders were able to profit by quickly trading in and out of funds and 

acting on information before other investors. The second type of abusive 

trading, known as “market timing,” is not illegal but may be used by 

investors to take advantage of temporary disparities between the value of 

a fund and the values of the underlying assets in the fund’s portfolio. 

These pricing disparities can occur frequently in certain funds such as 

those that invest in international markets where securities stop trading 

hours before American mutual funds typically calculate their net asset 

values. 

Both late trading and market timing impose costs on long-term 

shareholders. For example, when short-term traders purchase and redeem 

mutual fund shares, all investors share in the costs of fund managers 

buying or selling shares of securities held in the fund’s portfolio. Many 

mutual fund companies state in their fund prospectuses that they 

discourage market timing and may assess fees that are transferred to the 

fund if shares are sold within a certain period of time following a purchase 

of fund shares. However, some fund companies allowed certain investors 

to engage in market timing despite such language in their fund 

prospectuses. 

The Securities and Exchange Commission (SEC), which regulates the 

nation’s securities markets and mutual funds, has recently proposed 

regulations that are intended to stop late trading and reduce market 

timing. The Department of Labor (DOL) is not involved in the process of 

drafting the proposed late trading and market timing regulations because 

it does not regulate mutual funds. However, it is considering how the 

regulations would affect defined contribution plans, which frequently 

invest in mutual funds. The proposed regulations aimed at eradicating late 

trading would significantly change current industry practices in receiving 

and processing transaction requests from investors. Since many of the 

cases of late trading involved orders submitted through intermediaries not 

regulated by SEC, the proposed amendments would require that all fund 

 2

This report assumes, for convenience, that all funds price their securities daily at 4:00 p.m. 

eastern time. Some funds, however, price their securities more than once per day, and 

many funds price their securities earlier than 4 p.m. eastern time. 
Page 3 GAO-04-799 Mutual Funds 

transactions be received by mutual funds or designated processors (also 

regulated by SEC) before the market closing time of 4:00 p.m. eastern time 

to receive the same day’s price.3

 The proposed regulations intended to 

curb short-term trading, including market timing, would require mutual 

funds to impose a 2-percent fee—known as a redemption fee—on the 

proceeds of shares redeemed within 5 business days of purchase. Given 

the potential changes that would occur as a result of these new regulations 

and the importance of mutual funds to the retirement savings plans of 

millions of American workers, you asked us to 

• report on what is known about how market timing and late trading 

have affected the value of retirement savings of defined contribution 

plan participants, 

• describe what actions SEC and DOL have taken to address late trading 

and market timing, and 

• explain how defined contribution plan participants are likely to be 

affected by SEC’s proposed regulations. 

To determine how late trading and market timing have affected retirement 

savings in defined contribution plans, we reviewed academic studies about 

the effects of these practices on the values of mutual funds. We then 

compared this information with data from mutual fund companies and 

record keepers on how defined contribution plan participants allocate 

their retirement savings among mutual funds to assess their exposure to 

abusive trading practices. We also interviewed representatives of mutual 

fund companies, plan record keepers, and SEC officials to determine if 

they had any information about how late trading and market timing have 

affected the values of specific mutual funds. To learn about the regulatory 

actions taken by SEC and DOL, we interviewed agency officials and 

reviewed SEC’s proposed regulations and DOL’s guidance to plan 

sponsors on how to respond to late trading and market timing. To 

determine how defined contribution plan participants and service 

providers might be affected by SEC’s proposed regulations, we reviewed 

comment letters to SEC and interviewed SEC officials, representatives of 

mutual fund companies, plan record keepers, and employers. While 

mutual funds are common investment choices in many types of retirement 

 3

Types of intermediaries include broker-dealers, banks, insurance companies, and pension 

plan administrators, all of which may provide record-keeping services for pension plans. 

We refer to those that do as plan record keepers. 
Page 4 GAO-04-799 Mutual Funds 

savings plans, our analysis focuses on defined contribution plans because 

individual employees decide how to invest their retirement savings and 

thus they bear the risks of changes in the value of their accounts. We 

conducted our work between March 2004 and June 2004 in accordance 

with generally accepted government auditing standards. Appendix I 

describes the scope and methodology of our work in greater detail. 

The cost to long-term investors in mutual funds of late trading and market 

timing is unclear, however it does not appear that these trading abuses 

affected pension plan participants more than other investors. While costs 

of individual instances of abusive trading may not have had a noticeable 

effect on the value of fund shares held by long-term investors, the 

cumulative effect of such trading may be significant. Studies of late trading 

and market timing have yielded varying estimates of their cost to longterm fund investors. These differing results are one indication of the 

difficulty of measuring the extent and cost of late trading and market 

timing. Among 34 brokerage firms surveyed by SEC, including some of the 

largest in the nation, more than 25 percent reported instances of illegal 

late trading at their firms. However, one SEC official told us that the SEC 

views these survey results as conservative estimates of the extent of late 

trading, because there are numerous fund intermediaries that are not 

registered with and regulated by SEC who may also have allowed late 

trading to occur. The extent of market timing is also difficult to measure 

because fund intermediaries usually aggregate their clients’ fund 

transactions and do not necessarily share individual account information 

with mutual fund companies. Abusive trading appears to have varied 

among funds, in part because some funds went to greater lengths than 

others to try to prevent market timing. Ultimately, the effect of late trading 

and market timing on the savings of retirement plan participants and other 

long-term fund shareholders is a function of which funds they invested in 

and for how long. 

SEC and DOL have each taken steps to address abusive trading in mutual 

funds, and SEC has proposed regulations that aim to eradicate late trading 

and curb market timing. SEC investigations have led to settlements that, 

among other things, require those who engaged in abusive trading to 

return money to funds where late trading and market timing took place. In 

addition to its enforcement activities, SEC adopted new mutual fund 

disclosure requirements. DOL, meanwhile, has issued guidance to pension 

plan sponsors on how they and other plan fiduciaries can fulfill their legal 

requirements to act “prudently” and in the best interests of plan 

participants in offering investment options in their defined contribution 

Results in Brief 
Page 5 GAO-04-799 Mutual Funds 

plans. To stop late trading, SEC has proposed that all orders for fund 

transactions be received by mutual funds or designated processors, who 

are regulated by the SEC, before 4:00 p.m. eastern time in order to receive 

the same day’s price (the “Hard 4” proposal). According to SEC officials, 

this rule would effectively eliminate opportunities for late trading by fund 

intermediaries, where many cases of late trading took place. To address 

market timing, SEC’s proposed regulations would impose a 2-percent 

redemption fee on the proceeds of fund shares redeemed within 

5 business days of purchase. On the basis of comment letters and 

discussions with representatives of mutual funds and fund intermediaries, 

SEC officials are considering modifications and alternatives to these 

proposed regulations. DOL is not involved in the process of drafting the 

proposed late trading and market timing regulations because it does not 

regulate mutual funds. However, it anticipates assisting plan sponsors and 

record keepers on issues relating to how the final regulations affect 

defined contribution plans, which frequently invest in mutual funds. 

While SEC’s proposed regulations could both benefit and create new costs 

for all long-term mutual fund investors, defined contribution plan 

participants could be more adversely affected than other long-term 

investors. All long-term investors in mutual funds, including plan 

participants, would benefit if the proposals result in a cessation of late 

trading and a reduction in market timing. However, to comply with the 

requirements of SEC’s proposed regulations, mutual fund companies and 

fund intermediaries, including plan record keepers, are expected to incur 

costs, such as for upgrading their information systems. Many of these 

costs would likely be passed on to investors, plan participants, and plan 

sponsors. Plan participants would be distinctly affected by the late trading 

proposal because it creates potential complications for the processing of 

certain transactions unique to defined contribution plans, such as loans. 

For example, defined contribution plan participants sometimes borrow 

from their retirement savings, and plan record keepers need to know the 

value of the participant’s shares at the end of the day to be sure that the 

participant gets the amount requested and that the request complies with 

the rules of the pension plan. If record keepers had to submit orders to 

withdraw shares before share values are determined, as SEC’s proposed 

rule would require, participants could receive incorrect loan amounts and 

in some cases the loan amount could be greater than allowed by the 

pension plan rules. The market timing proposal could result in plan 

participants paying fees that are intended to deter market timing, even on 

certain transactions, such as occasional transfers between funds to meet 

an investor’s investment objectives, for which clearly no intent to engage 

in abusive trading exists. While SEC attempted to address these potential 
Page 6 GAO-04-799 Mutual Funds 

negative effects by including certain exceptions to the application of the 

redemption fee, there are still some cases in which a plan participant 

could be charged such a fee. Therefore, SEC officials have told us that, as 

of this writing, they are considering modifications or alternatives to the 

proposed regulations that would prevent these problems from occurring. 

Given the significant role that mutual funds play in retirement savings, we 

are recommending that the SEC Commissioners adopt certain 

modifications or alternatives to the proposed regulations that are currently 

under consideration in order to prevent pension plan participants from 

being more adversely affected than other investors. In its response to our 

draft report, SEC agreed with our analysis and noted that the commission 

staff is considering modifications to the proposals that should mitigate 

certain circumstances that could adversely affect pension plan 

participants (SEC’s comments are reproduced in app. III). 

Mutual funds are structured so that each investor in the fund owns shares, 

which represent a percentage of the fund’s investment portfolio, and 

investors share in the fund’s gains, losses, and its costs. Mutual fund 

families offer investors multiple funds from which to choose, each with its 

own level of risk and investment objective, such as international equities 

or U.S. government bonds. Investors may usually exchange assets between 

funds within a fund family at any time. 

Recent investigations of mutual fund trading by the SEC and some state 

attorneys general have revealed cases of abusive trading practices. Mutual 

funds have proven to be a vehicle for abusive trading for a few reasons, 

such as 

• Inefficient pricing of certain funds. Mutual funds typically determine 

their net asset values once a day, based on the prices of their underlying 

securities at 4:00 p.m. eastern time. For funds invested in equities that 

trade on international stock exchanges, the most current prices for those 

underlying assets may be as much as 15 hours old and thus not reflect 

more recent information that may affect the prices of those assets. When 

the prices of underlying securities do not reflect the most current 

information that is likely to affect their price, opportunities are created for 

arbitrage, or profitably exploiting price differences of identical or similar 

financial instruments, usually over a short time period. 

• Free fund exchanges. Abusive market timing sometimes took place 

because investors took advantage of the fact that fund families often allow 

Background 
Page 7 GAO-04-799 Mutual Funds 

their fund shareholders to purchase, redeem, or exchange funds at no cost 

for a specific transaction. Normally, investors may redeem their shares on 

any business day. 

• Difficulty of identifying trading abuses. In many cases trading abuses 

were committed by investors who purchased and redeemed fund shares 

through intermediaries, who are not required to share information about 

their clients’ transactions with mutual fund companies. Most funds are 

sold via intermediaries such as broker-dealers, banks, and pension plans. 

To simplify and reduce the costs of mutual fund transactions, 

intermediaries collect orders throughout the day and then aggregate all the 

transactions they receive for a particular fund. Those intermediaries that 

are licensed as broker-dealers may net, or match, purchase and 

redemption orders for the same funds among their own clients. In a 

simplified example, if one investor were to purchase 15 shares of fund A, 

and another investor were to redeem 10 shares of fund A, at the end of the 

day the intermediary would simply transmit one order to purchase 

5 shares of fund A—the net result of the day’s orders. Intermediaries then 

transmit the net results of aggregate transactions to the mutual fund 

companies, where intermediaries hold omnibus accounts representing the 

collective shares of their clients. Mutual fund companies generally do not 

have information about the identities and specific transactions of the 

individual investors in intermediaries’ omnibus accounts. Intermediaries 

have contact with their clients, such as defined contribution plan 

participants and other individual investors (“retail investors”), and control 

access to information about their trading activity. Because intermediaries 

do not typically share this information with mutual funds, the fund 

companies often cannot discern whether these investors are frequently 

trading in and out of their funds. 

Mutual fund intermediaries accept purchase and redemption orders 

throughout the day and are required to stop accepting trades at 4:00 p.m. 

eastern time for those transactions that will receive the same day’s net 

asset value. According to SEC rule 22c-1 under the Investment Company 

Act of 1940, purchase and redemption orders submitted by investors to a 

fund or fund intermediary before the fund next determines its net asset 

value (usually at 4:00 p.m.) must be executed at that next-computed net 

asset value. Presently, intermediaries are allowed to aggregate orders after 

4:00 p.m. and submit them as omnibus account transactions later in the 

evening for settlement to mutual fund companies, either directly or via 
Page 8 GAO-04-799 Mutual Funds 

their transfer agents4 or the National Securities Clearing Corporation 

(NSCC), an SEC-registered clearing agency.5

 An intermediary or mutual 

fund that allows investors to engage in late trading could therefore 

aggregate orders received both before and after 4:00 p.m. and process 

them as if they had all arrived before 4:00 p.m. Figure 1 illustrates the 

process of how orders for mutual fund transactions are transmitted from 

investors and plan participants to mutual fund companies. 

 4

Mutual funds employ transfer agents to conduct record-keeping and related functions. 

Transfer agents maintain records of shareholder accounts, calculate and disburse 

dividends, and prepare and mail shareholder account statements, federal income tax 

information, and other shareholder notices. 

5

NSCC is currently the only clearing agency registered with the SEC that operates an 

automated system, called Fund/SERV, for processing orders for mutual funds and other 

securities. Fund/SERV provides a central processing system that collects order information 

from clearing brokers and others, sorts all the incoming order information according to 

fund, and transmits the order information to each fund’s primary transfer agent. 
Page 9 GAO-04-799 Mutual Funds 

Figure 1: Path of Mutual Fund Transactions 

Note: Many mutual fund companies act as their own transfer agents, while other funds hire transfer 

agents to keep records on their behalf. Mutual fund companies may act as plan record keepers and 

only offer proprietary mutual funds to plan participants; thus, plan participants sometimes submit 

orders directly to mutual fund companies. 

Most employers that sponsor defined contribution plans contract out the 

various administrative tasks of plan record keeping to companies that 

have expertise in the administration of plans or investments. Pension plan 

record keepers keep track of day-to-day transactions for each plan 

participant’s account. The record keeper is responsible for transactions 

such as crediting accounts with employee and employer contributions, 

processing changes in participant-directed investment allocations, 

updating account values (usually each business day) to reflect changes in 

the values of mutual fund shares held by each plan participant, and acting 

as a mutual fund intermediary when participants make exchanges between 

funds. When a plan participant sends the record keeper a request for a 

transaction, such as for a loan, the record keeper must determine whether 

the request can be approved in accordance with federal tax and pension 

laws and the rules of the company’s pension plan. In addition, record 

keepers may function as the primary source of plan information and 

customer service for plan participants. 

Plan participant(s) Retail investor(s)

NSCC

Mutual fund/

Transfer agent

4:00 p.m. deadline

by which orders must be received

or

(Transactions in like funds

are aggregated or netted)

Single transaction order

Order placed after 4:00 p.m. (potential for late trading)

Source: GAO.

Processing

and recording

Intermediary/

Plan record

keeper
Page 10 GAO-04-799 Mutual Funds 

Pension plan sponsors often hire a mutual fund company or a plan record 

keeper to administer their defined contribution plans. Plans administered 

by a record keeper frequently offer an “open-architecture plan” that permit 

participants to invest in mutual funds offered by a variety of mutual fund 

companies. The record keeper itself may be one of these companies, 

insofar as some companies that are primarily record keepers also offer 

their own proprietary mutual funds. Plans administered by a mutual fund 

provider will typically include investment choices offered by that mutual 

fund provider, and may or may not offer funds of other mutual fund 

companies. In recent years, open-architecture plans have become more 

common among defined contribution plans. 

Mutual funds are subject to SEC registration and regulation, and are 

subject to numerous requirements established for the protection of 

investors. Mutual funds are regulated primarily under the Investment 

Company Act of 1940 and the rules and registration forms adopted under 

that act. The 1940 act grants SEC broad discretionary powers to keep the 

act current with the constantly changing financial services industry 

environment in which mutual funds and other investment companies 

operate. The primary mission of the SEC is to protect investors, including 

pension plan participants investing in securities markets, and maintain the 

integrity of the securities markets through extensive disclosure, 

enforcement, and education. In addition to regulating mutual funds, SEC 

also regulates some of the intermediaries that act as brokers of mutual 

funds, such as retail broker-dealers and certain pension plan record 

keepers. However, fund intermediaries that are not registered as brokerdealers are outside SEC’s jurisdiction. For example, insurance companies 

are regulated by state authorities, banks are regulated by the Office of the 

Comptroller of the Currency (OCC) and other bank regulators, and 

pension plan administrators are regulated by DOL. These regulators are 

required to perform a number of oversight functions—for example, OCC 

examines the safety and soundness of certain types of banks—therefore, 

identifying infractions of SEC trading regulations is not the focus of their 

regulatory activity. 

Pursuant to the Employee Retirement Income Security Act of 1974 

(ERISA), DOL enforces reporting and disclosure provisions and fiduciary 

responsibility standards of private employer-sponsored pension plans. 

While ERISA does not provide specific guidance regarding the steps a plan 

fiduciary may or should take with regard to late trading and market timing, 
Page 11 GAO-04-799 Mutual Funds 

ERISA established the broad fiduciary requirements relating to private 

pension plans and was designed to protect the rights of plan participants 

and their beneficiaries.6

 ERISA Section 401(b)(1) of Title I provides that a 

plan which invests in a security issued by an investment company 

registered under the Investment Company Act of 1940, such as mutual 

fund shares, is only investing in the “security” or shares of that investment 

company and not in the underlying assets of the investment company. The 

asset of the plan is the issued security, not any of the assets held by the 

investment company. Therefore, under ERISA, DOL does not regulate the 

activities of an investment company. 

The cost to long-term mutual fund investors of late trading and market 

timing is unclear, however it does not appear that these trading abuses 

affected pension plan participants differently than other long-term 

investors. While costs of individual instances of late trading and market 

timing may not have a noticeable effect on the value of fund shares held by 

long-term investors, the cumulative effect of abusive trading may have 

been significant. Studies of late trading and market timing have yielded 

varying estimates of their cost to long-term fund investors. The extent of 

abusive trading appears to have varied among funds, in part because some 

funds went to greater lengths than others to try to prevent trading abuses. 

Ultimately, the effect of late trading and market timing on the savings of 

retirement plan participants and other long-term fund shareholders is a 

function of which funds they invested in and for how long. 

When some investors are allowed to frequently buy into a fund to benefit 

from its short-term increases in value and sell shares to avoid its decreases 

in value, there is a three-fold negative impact on the fund’s long-term 

shareholders: 

• Costs increase. Abusive trading generates greater transaction costs 

because fund managers have to more frequently buy or sell shares of the 

 6

ERISA generally defines a plan fiduciary as a person who, among other things, exercises 

discretionary control or authority over the management of a pension plan or any authority 

or control respecting management or disposition of its assets. Fiduciaries often include the 

plan sponsor and the investment adviser. 

Mutual Fund Trading 

Abuses Affected 

Pension Plan 

Participants but the 

Extent Is Unclear 

Abusive Short-Term 

Trading Imposes Costs on 

Long-Term Shareholders 
Page 12 GAO-04-799 Mutual Funds 

underlying securities in the fund’s portfolio to match demand for fund 

shares.7

• Investment returns usually decline over time. Abusive trading usually 

results in lower investment returns over the long term when fund 

managers hold a greater percentage of the fund’s assets in cash. Fund 

managers often increase the percentage of fund assets held in cash in 

order to accommodate short-term traders’ redemptions of shares without 

having to engage in cost-generating transactions of buying and selling 

shares of the fund’s underlying securities. Over the long term, investments 

in cash have yielded lower investment returns than stocks and bonds.8

• Gains are diluted. If short-term traders purchase fund shares and redeem 

them before their money can be invested in the fund’s portfolio, they share 

in increases in the fund’s value, resulting in long-term shareholders 

receiving a smaller share of these gains—a dilution of fund gains. 

Conversely, short-term traders can often avoid losses by redeeming fund 

shares before their value decreases, resulting in long-term investors 

sharing in a higher proportion of the fund’s decrease in value. 

Figure 2 demonstrates the dilution effect of abusive short-term trading on 

long-term shareholders. 

 7

Unlike publicly traded corporate stock, the number of allowable shares in a mutual fund 

are not finite, since shares may be created and eliminated as investors purchase and 

redeem them. 

8

Over the short term, in a portfolio that is declining in value, a greater cash position may 

help to limit the decline in the fund’s net asset value. 
Page 13 GAO-04-799 Mutual Funds 

Figure 2: Comparison of Fund Net Asset Value with and without Market Timing 

Note: The figure shows how a hypothetical mutual fund is affected by an increase in its portfolio 

assets with and without market timing. In this example, a market timer invests $1,000 in the fund on 

day 1 before a 10 percent rise in the value of the securities held by the fund. On day 2 the market 

timer redeems the shares, yielding a reduction in the fund’s net asset value compared to its value 

without a market timer transaction. The example assumes that the portfolio manager is unable to 

invest the market timer’s cash and thus that amount does not help increase the fund’s gain when the 

market rises. 

While a short-term trader can earn large returns from late trading or 

market timing, the costs of such trades are generally imposed on a large 

population of shareholders and therefore have a relatively small effect on 

each individual investor. As shown in the example in figure 2, market 

$1,000

Portfolio securities

Cash

Total assets

Shares

Net asset value

$90,000

$10,000

$100,000

10,000

$10.00

$90,000

$11,000

$101,000

10,100

$10.00

$99,000

$11,000

$110,000

10,100

$10.89

$99,000

$10,000

$109,000

10,000

$10.90

$99,000

$9,911

$108,911

10,000

$10.89

Market timer

buys 100 shares

$1,089

Day

1

Day

2

With

market

timing

With no

market

timing

With

market

timing

With no

market

timing

10% rise in

price of securities

Holdings of fund

at end of day 2

Calculation of net asset 

value after 10% rise and 

$1,000 investment by 

market timer

+

=

=

÷

Source: GAO.

Fund redeems market

timer's 100 shares at day 2

net asset value
Page 14 GAO-04-799 Mutual Funds 

timing reduces the net asset value of a share from $10.90 to $10.89, or less 

than 0.1 percent. However, abusive short-term trading on a large scale and 

over a period of years could cost long-term shareholders, such as plan 

participants, more significant percentages of their assets. 

Efforts to quantify the total extent and cost of late trading and market 

timing have yielded varying results. One academic study found evidence of 

late trading in 15 of a sample of 50 international funds, and in 12 of a 

sample of 96 domestic equity funds between 1998 and 2001.9

 On the basis 

of these samples, the study estimates that during 2001, late trading diluted 

the gains of the average long-term shareholder in international and 

domestic equity funds by 0.05 and 0.006 percent, respectively. We were 

unable to identify other studies on the extent of late trading, though 

representatives of a mutual fund trade association that we spoke with 

believe that these estimates are too high. Market timing also appears to 

have been most prevalent in international equity funds, according to both 

academic studies and representatives of mutual fund companies we spoke 

with. Studies show that the most profitable market timing strategies 

involved trading in and out of international equity funds. Other funds that 

were used for market timing were small and midsize company domestic 

equity funds and some types of bond funds. According to one study, 

market timing has more negatively affected long-term shareholders than 

late trading.10 Among the seven studies about market timing we reviewed, 

estimates of its cost ranged from averages of 0.32 to 2.3 percent of assets 

per year in international equity funds.11 The differences in the estimated 

costs of market timing vary depending on which data and methodology 

were used by the researchers. These variations also indicate the difficulty 

 9

E. Zitzewitz, “How Widespread Is Late Trading in Mutual Funds?” Stanford Graduate 

School of Business Research Paper Series (2003). The study notes that the existence of late 

trading in a mutual fund does not necessarily imply that the fund itself colluded with late 

traders. Many instances of late trading occurred among fund intermediaries. 

10Zitzewitz, 2003. 

11W.N. Goetzmann, Z. Ivkovic, and K.G. Rouwenhorst, “Day Trading International Mutual 

Funds: Evidence and Policy Solutions,” Journal of Financial and Quantitative Analysis 

Vol. 36, No. 3 (2001); and E. Zitzewitz, “Who Cares About Shareholders? Arbitrage-Proofing 

Mutual Funds,” The Journal of Law, Economics, and Organization Vol. 19, No. 2 (2003). 

These studies note that the effect of market timing varied by type of international fund. 

Among these studies, four provided estimates of the effect of market timing on the values 

of mutual funds. The studies cited above include the minimum and maximum estimates of 

the costs of market timing. See appendix I for more details. 

Extent of Mutual Fund 

Trading Abuses Is Unclear 
Page 15 GAO-04-799 Mutual Funds 

of definitively calculating the extent of mutual fund trading abuses and 

their effect on long-term investors. 

The extent of late trading and market timing is very difficult to measure 

because these practices can be hard to identify. Many cases of late trading 

occurred at the fund intermediary level, when orders were illegally 

accepted after 4:00 p.m. and given the same day’s price when they were 

combined with orders accepted before 4:00 p.m. Among 34 brokerage 

firms surveyed by SEC, including some of the largest in the nation, more 

than 25 percent reported instances of illegal late trading at their firms. 

However, one SEC official told us that SEC views these survey results as 

conservative estimates of the extent of late trading, particularly because 

there are numerous intermediaries that sell mutual funds, including a 

significant percentage that are not registered with and regulated by SEC. 

In one case of late trading, SEC brought charges against Security Trust 

Corporation, a national bank association, for allowing Canary Capital 

Partners, a hedge fund, to submit trades after the close of the market and 

receive same day pricing.12 Security Trust then aggregated these illegal 

transactions with legitimate retirement plan transactions and submitted 

orders after 4:00 p.m. that appeared to be legal to fund companies. 

Security Trust Corporation has been closed by federal regulators. 

According to SEC officials, audits of past transactions cannot identify 

many instances of late trading because late traders often submitted orders 

before 4:00 p.m. and then were allowed to cancel those orders after the 

market closed. Canceled orders were then destroyed, which left no record 

of the illegal trading. 

Market timing can also be difficult to identify because, among other 

reasons, the omnibus accounts of intermediaries obscure individual 

account transactions. Therefore, mutual fund companies cannot identify 

the frequency at which an individual investor is exchanging money 

between funds. SEC has alleged that one intermediary’s methods included 

(1) forming and registering two affiliated broker-dealers through which the 

intermediary could continue to engage in market timing without detection, 

(2) changing account numbers for blocked customer accounts, (3) using 

alternative registered representative numbers for registered 

 12The term “hedge fund” generally identifies an entity that holds a pool of securities and 

perhaps other assets that does not register its securities offerings under the Securities Act 

and which is not registered as an investment company under the Investment Company Act 

of 1940. Hedge funds are also characterized by their fee structure, which compensates the 

adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation. 
Page 16 GAO-04-799 Mutual Funds 

representatives who were blocked from trading by mutual funds, (4) using 

different branch identification numbers, (5) switching clearing firms, and 

(6) suggesting that customers use third-party tax identification numbers or 

Social Security numbers to disguise their identities. 

Retirement plan participants would have been affected by late trading and 

market timing just like other long-term investors if they were shareholders 

in funds where these trading abuses occurred. Since trading abuses appear 

to have been concentrated in international equity funds, those plan 

participants that invested in such funds would likely have been affected by 

late trading and market timing.13 However, even among investors in 

international equity funds, some were probably affected more than others 

because some mutual funds have successfully reduced market timing by 

employing various tools such as fair value pricing, redemption fees, and 

other penalties against frequent traders.14 According to news reports and 

SEC officials, some plan sponsors have responded to mutual fund trading 

abuses by reassessing the investment options they offer to their plan 

participants, and in some cases have removed implicated funds from their 

offerings. Nonetheless, some funds that tried to stop market timing could 

still have been used by abusive short-term traders who traded via 

intermediaries. Most of the assets of plan participants were not affected by 

market timing in international equity funds because, as shown in figure 3, 

less than 10 percent of all plan assets were invested in international equity 

funds. 

 13Investors outside of international equity funds may also have been affected by market 

timing as some short-term traders exchanged money back and forth between international 

funds and other funds. Aside from money market funds, we were unable to determine 

which types of funds market timers used. The value of money market funds should not 

have been affected by market timing because they hold highly liquid assets and are 

intended to maintain a stable value of $1.00 per share. 

14Fair value pricing is a process that mutual funds use to value fund shares (such as for 

assets traded in foreign markets) in the absence of current market values. SEC requires 

that when market quotations for a portfolio security are not readily available, a fund must 

calculate its fair value. 

Effect of Mutual Fund 

Trading Abuses on Plan 

Participants Varies 
Page 17 GAO-04-799 Mutual Funds 

Figure 3: Mutual Fund Defined Contribution Plan Assets by Type of Fund 

Note: Hybrid funds invest in a mix of equity and fixed-income securities. 

According to a study by the Investment Company Institute, international 

equity funds make up less than 10 percent of total defined contribution 

assets in mutual funds.15 However, according to two of the nation’s largest 

pension plan record keepers, at least 19 percent of plan participants, for 

whom they keep records, invest at least part of their retirement savings in 

international equity funds. Furthermore, any individual investor may 

allocate his or her plan assets very differently from the average. 

Market timing can also harm plan participants if a plan sponsor fails or 

refuses to limit a participant’s market timing. In pension plans, even where 

a fund company becomes aware of a participant that is engaged in harmful 

market timing, the fund’s ability to restrict only the participant, and not the 

entire plan, may be limited because the shares of all participants are held 

 15The Investment Company Institute is the national association of the U.S. mutual fund 

industry. Its membership includes approximately 8,595 mutual funds (including about 400 

fund families) and manages about 95 percent of mutual fund assets in the U.S. mutual fund 

industry. 

Bond

Money

market

Hybrid

International

equity

Domestic

equity

Bond

Money

market

Hybrid

International

equity

Domestic

equity

1999 2002

5%

6%

8%

8%

73%

7%

10%

11%

11%

61%

International equity mutual fund (typically where market timing takes place)

Source: GAO, based on data from the Investment Company Institute.
Page 18 GAO-04-799 Mutual Funds 

in the record keeper’s omnibus account. If a plan sponsor fails or refuses 

to act to stop a participant engaged in market timing, a fund has few 

means with which to stop the market timer, except for perhaps restricting 

access to the fund for all the plan’s participants. According to 

representatives of one mutual fund trade association we spoke with, plan 

sponsors have sometimes been reluctant to impose redemption fees or 

trading restrictions on plan participants for fear that they may be sued for 

fiduciary violations. 

SEC and DOL have each taken steps to address abusive trading in mutual 

funds, and SEC has proposed regulations that aim to eradicate late trading 

and curb market timing. SEC has been investigating and has settled several 

cases of abusive trading in mutual funds and has recently adopted new 

mutual fund disclosure requirements. DOL, meanwhile, is conducting its 

own investigations and has issued guidance to pension plan sponsors that 

covers, among other things, their responsibilities to ensure that they are 

offering prudent investment options to plan participants. SEC’s proposed 

regulations on late trading would amend the rule that governs how mutual 

funds price and receive orders for share purchases and redemptions. To 

try to curb market timing, a separate SEC proposal would require mutual 

funds to impose a 2-percent redemption fee on the proceeds of shares 

redeemed within 5 business days of purchase. 

SEC has already settled some cases of late trading and market timing 

abuses with mutual fund companies, hedge funds, and brokers. Though 

market timing is not illegal, SEC has charged fund companies with 

defrauding investors by not enforcing their stated policies of discouraging 

or prohibiting market timing, as written in their prospectuses. Some 

institutions have been fined hundreds of millions of dollars, and part of 

this money will be returned to long-term fund shareholders who lost 

money from these abusive trading practices. Furthermore, SEC has 

permanently barred some of the individuals at these companies from 

future work with investment companies and is seeking disgorgement and 

civil penalties against them.16 SEC officials told us that more enforcement 

actions are pending. 

 16Disgorgement is a remedy that requires a violator of federal securities law to give back to 

investors money obtained as a result of the violation. 

Regulators Are Taking 

Actions to Address 

Abusive Mutual Fund 

Trading 

SEC and DOL Have Taken 

Steps to Enforce and 

Clarify Existing Laws 

under Their Respective 

Jurisdictions 
Page 19 GAO-04-799 Mutual Funds 

In addition to its enforcement actions, SEC has issued guidance and new 

regulations that address the negative impact of market timing on long-term 

shareholders. In 2002, SEC issued guidance stating that mutual funds may 

delay exchanges of shares from one fund to another in order to combat 

market timing. Permitting delayed exchanges could deter market timing, 

since market timers seek to effect transactions on a specific day to take 

advantage of perceived market conditions. SEC also issued new 

regulations in April 2004 that require mutual funds to disclose the 

following information in their prospectuses: 

• risks to shareholders of frequent purchases and redemptions of shares, 

• policies and procedures regarding frequent purchases and redemptions of 

shares, 

• circumstances under which they will use fair value pricing and the effects 

of using fair value pricing, and 

• policies and procedures with respect to the disclosure of their portfolio 

securities and any ongoing arrangements to make available information 

about their portfolio securities. 

Mutual funds must comply with these new regulations by December 5, 

2004. 

Separate from SEC’s activities, DOL has also begun investigating possible 

fiduciary violations at some large investment companies, including those 

that sponsor mutual funds, intermediaries, and plan fiduciaries. More 

specifically, DOL is determining whether any of ERISA’s fiduciary 

provisions were violated by offering investments in funds that allowed late 

trading or market timing, and whether employee benefit plans incurred 

any financial losses as a result. Among other things, DOL expects to 

address 

• whether plan fiduciaries used pension plan accounts to facilitate late 

trading or market timing of others, 

• whether pension plans incurred losses as a result of fiduciaries knowingly 

directing investments in mutual funds that permitted late trading or 

market timing, and 

• whether plan fiduciaries appropriately monitored plan provisions 

regarding market timing. 
Page 20 GAO-04-799 Mutual Funds 

DOL also issued a statement in February 2004 suggesting that plan 

fiduciaries review their relationships with mutual funds and other 

investment companies to ensure that they are meeting their 

responsibilities of acting reasonably, prudently, and solely in the interest 

of plan participants. According to DOL, for those mutual funds under 

investigation for trading abuses, fiduciaries should consider the nature of 

the alleged abuses, the potential economic impact of those abuses on the 

plan’s investments, the steps taken by the fund to limit the potential for 

such abuses in the future, and any remedial action taken or contemplated 

to make investors whole. For funds that are not under investigation, DOL 

suggested that fiduciaries review whether funds have procedures and 

safeguards in place to limit their vulnerability to trading abuses. 

The DOL guidance also explains that if a plan offers mutual funds or 

similar investments that impose reasonable redemption fees on sales of 

their shares, this would, in and of itself, not affect the availability of relief 

to the plan sponsor under Section 404(c) of ERISA.17 The guidance adds 

that reasonable plan or investment fund limits on the number of times a 

participant can move in and out of a particular investment within a 

particular period would not run afoul of requirements under 404(c). 

However, the terms and conditions of the plan regarding the imposition of 

fees and trading restrictions must be clearly disclosed to the plan’s 

participants and beneficiaries. Representatives of mutual fund companies 

and plan sponsors have told us that additional guidance on what actions 

plan sponsors may take to prevent market timing by plan participants, 

without losing relief under ERISA Section 404(c), would be helpful. 

In addition to adopting new mutual fund disclosure requirements, SEC has 

also proposed regulations to address late trading and market timing 

abuses. In December 2003, SEC proposed amending the rule that governs 

how mutual funds price and receive orders for share purchases or sales.18

Since many of the cases of late trading involved orders submitted through 

intermediaries, including banks and pension plans not regulated by SEC, 

 17ERISA Section 404(c) generally provides relief for plan fiduciaries of certain individual 

account plans, such as 401(k) plans, from liability for the results of investment decisions 

made by plan participants and beneficiaries, under conditions specified in 29 CFR 

§2550.404c-1. 

18Securities and Exchange Commission, Proposed Rule: Amendments to Rules Governing 

Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec. 11, 2003). 

SEC Has Proposed New 

Mutual Fund Trading 

Regulations 
Page 21 GAO-04-799 Mutual Funds 

the proposed amendments would require that orders to purchase or 

redeem mutual fund shares be received by a fund, its transfer agent, or a 

registered clearing agency before the time of pricing (usually 4:00 p.m. 

eastern time). SEC officials explained to us that given their resources, they 

cannot examine all intermediaries that accept order information for 

mutual fund shares. Thus, to lower the risk of additional late trading 

abuses, it would be necessary to reduce the number of fund intermediaries 

with the authority to verify the time that orders are received. 

To stem market timing, SEC proposed a new rule in March 2004 to require 

mutual funds to impose a 2-percent redemption fee on the proceeds of 

shares redeemed within 5 business days of purchase.19 According to the 

proposal, the proceeds from the redemption fees would be retained by the 

fund and would become a part of the total assets managed on the behalf of 

the fund’s shareholders. The imposition of a mandatory redemption fee is 

intended to serve two purposes: (1) to reimburse a fund for the 

approximate costs of short-term trading in fund shares, and (2) to 

discourage short-term trading by reducing its profitability. SEC is aware 

that the redemption fee by itself is inadequate for eliminating all profitable 

market-timing opportunities. Therefore, fund companies may use 

additional measures to try to prevent market timing. In addition, the 

proposal requires all fund intermediaries, including plan record keepers, to 

share the details of each client’s transactions with mutual fund companies. 

On at least a weekly basis, intermediaries would be required to provide 

mutual funds with purchase and redemption information for each 

shareholder within an omnibus account to enable the fund to detect 

market timers and ensure that redemption fees are properly assessed. 

Presently, those intermediaries that are not under the jurisdiction of SEC 

cannot be required by SEC to share individual account information with 

mutual fund companies. The proposal also allows for certain exceptions to 

the application of the redemption fee, such as for unanticipated financial 

emergencies, and for redemptions of $2,500 or less if the fund chooses to 

adopt such a policy. 

These proposals are part of an open regulatory process, and according to 

SEC officials, SEC staff have reviewed over 1,400 comment letters and met 

with various interested parties. SEC officials are considering modifications 

to the proposals based on feedback from different parties and will 

 19Securities and Exchange Commission, Proposed Rule: Mandatory Redemption Fees for 

Redeemable Fund Securities, Release No. IC-26375A (Mar. 5, 2004). 
Page 22 GAO-04-799 Mutual Funds 

ultimately recommend a final set of proposals to the Commissioners of the 

SEC. SEC also proposed new regulations that address mutual fund boards’ 

independence and effectiveness, fund adviser compensation of brokerdealers that sell fund shares, and mutual fund ethics standards.20 SEC 

officials told us that these rules and others should help reduce abusive 

practices, such as late trading and market timing, throughout the mutual 

fund industry. DOL is not involved in the process of drafting the proposed 

late-trading and market-timing regulations because it does not regulate 

mutual funds. However, it is considering how the regulations would affect 

pension plans and anticipates providing interpretative assistance to plan 

sponsors and record keepers, as necessary, regarding any ERISA issues in 

implementing SEC’s final rules. 

SEC’s proposed regulations on late trading and market timing would have 

similar effects on pension plan participants and other investors, but as 

they were initially written they would also have some effects unique to 

defined contribution plan participants. To the extent that the proposals 

would result in a cessation of late trading and a reduction in market 

timing, plan participants, like other mutual fund investors, would benefit. 

However, SEC’s proposed regulations are expected to create additional 

costs for mutual fund companies and fund intermediaries, including plan 

record keepers; many of these costs are likely to be passed on to investors, 

plan participants, and plan sponsors. Plan participants could be distinctly 

affected by the late trading proposal because it creates potential 

complications for the processing of certain transactions unique to defined 

contribution plans, such as loans. In addition, plan participants may pay 

fees intended to deter short-term trading, including market timing, even on 

certain transactions where there is clearly no intent to engage in abusive 

trading. 

 20See (1) Securities and Exchange Commission, Proposed Rule: Investment Company 

Governance, Release No. IC-26323 (Jan. 15, 2004); (2) Securities and Exchange 

Commission, Proposed Rule: Prohibition on the Use of Brokerage Commissions to Finance 

Distribution, Release No. IC-26356 (Feb. 24, 2004); and (3) Securities and Exchange 

Commission, Proposed Rule: Investment Adviser Code of Ethics, Release No. IC-26337 

(Jan. 20, 2004). For assessment of some of these proposals see U.S. General Accounting 

Office, Mutual Funds: Assessment of Regulatory Reforms to Improve the Management 

and Sale of Mutual Funds, GAO-04-533T (Washington, D.C.: March 10, 2004). 

Most Plan 

Participants Could 

Benefit from SEC’s 

Proposed Regulations 

but Face Greater 

Costs than Other 

Investors 
Page 23 GAO-04-799 Mutual Funds 

To the extent that SEC proposals would result in a cessation of late 

trading and a reduction in market timing, plan participants, like other 

mutual fund investors, would benefit. SEC officials told us that the Hard 

4 proposal would virtually eliminate the possibility of late trading through 

mutual fund intermediaries. Participants could also benefit from the 

redemption fee proposal, as many short-term traders are likely to be 

deterred from abusive market timing that imposes costs on long-term 

investors. Furthermore, those who engage in market timing would repay 

to long-term shareholders at least part of the costs that they impose on 

them. 

According to SEC officials, pension plan participants and other fund 

investors would also benefit from increased confidence in the fairness of 

the securities markets, knowing that these two types of abusive trading 

practices were being minimized. Market fairness and the promotion of 

investor confidence have long been goals of the SEC. The persistence of 

late trading and market timing could undermine the integrity of, and 

investor confidence in, the securities markets in general and mutual funds 

in particular. SEC officials told us that not acting quickly to address these 

abuses could have resulted in investors withdrawing mutual fund 

investments and either looking for other investment options or 

withdrawing from securities markets entirely. 

SEC’s proposed regulations on late trading and market timing are 

expected to create additional costs for mutual funds and fund 

intermediaries, including pension plan record keepers, which would likely 

result in increased costs for all mutual fund investors, plan participants, 

and plan sponsors.21 SEC’s late trading proposal could force intermediaries 

to require their clients, including pension plan participants, to submit their 

orders for mutual fund transactions prior to 4:00 p.m. eastern time. 

Pension plan administrators anticipate that retirement plan participants 

who submit orders through intermediaries would face cutoffs between 

12:00 p.m. and 2:00 p.m. eastern time in order to allow pension plan record 

keepers time to process purchase and redemption orders before 

submitting them to the fund, its transfer agent, or NSCC. This earlier 

deadline for submitting fund transaction orders to plan record keepers 

 21Mutual fund transfer agents and NSCC would also face increased costs from 

implementation of the proposed regulations. Many of these costs are likely to be passed on 

to the mutual funds and fund intermediaries who use their services. 

Plan Participants Would 

Benefit from a Cessation 

of Trading Abuses 

New Regulations Are 

Expected to Impose Costs 

on Service Providers and 

Investors 
Page 24 GAO-04-799 Mutual Funds 

should not significantly affect payroll transactions of fund shares because 

these transactions are a function of the participant’s payroll schedule and 

not usually timed investment decisions made by the plan participant; 

therefore, the change in price from one day to the next could either be to 

the benefit or the detriment of plan participants as they purchase or 

redeem shares at higher or lower prices. According to representatives of 

two large mutual fund companies that we spoke with, payroll transactions 

represent about 95 percent of the defined contribution plan transactions 

that they process. However, some pension plan administrators told us that 

in some cases of nonpayroll transactions, they may not be able to process 

any purchase and redemption requests the same day that orders are 

received. SEC officials told us that implementation of computer system 

upgrades and modifications to business processes would likely result in 

intermediaries ultimately being able to accept orders until a time very 

shortly before 4:00 p.m. eastern time. However, some intermediaries told 

us that system upgrades and the communication of information to 

investors, plan participants, and plan sponsors about new requirements for 

submitting orders for mutual fund transactions could represent a 

significant expense. 

Some pension plan record keepers told us that adoption of the 

Hard 4 proposal would put intermediaries at a competitive disadvantage if 

they were unable to modify their systems so that plan participants would 

be able to submit orders until 4:00 p.m. (or just before then). They argued 

that investors, including plan participants, have grown accustomed to 

ever-increasing rates of change in global financial markets and that plan 

participants want the flexibility to move their money at a moment’s notice, 

without having to wait a day for the transaction to be completed. Indeed, 

on some of the stock market’s most volatile days there have been 

increases in the percentage of plan participants who exchange money 

between funds. As a result of this demand, plan record keepers fear that 

they would not be able to compete with mutual fund companies, who offer 

their own funds and record-keeping services to pension plans and could 

therefore allow plan participants to submit orders until 4:00 p.m.22 Officials 

of one mutual fund company that also serves as a record keeper expressed 

concerns that plan participants may demand alternative investment 

products to mutual funds if they were to no longer be able to place orders 

 22Some plan record keepers and mutual fund companies have suggested alternative 

regulations to the SEC’s Hard 4 proposal. Appendix II describes these alternatives and 

some of the concerns that have been raised about them. 
Page 25 GAO-04-799 Mutual Funds 

for fund transactions until the market closing time. However, according to 

information from two of the nation’s largest mutual fund companies, the 

vast majority of plan participants do not make more than one exchange 

between mutual funds during the course of a year. 

The redemption fee proposal would also create new costs for mutual 

funds and their intermediaries. SEC has noted that the costs to a fund’s 

transfer agent to store the shareholder information and track the trading 

activity may be significant and those costs may ultimately be passed on to 

investors. In some cases, the transfer agent would have to upgrade its 

record-keeping systems. Commenting on the information-sharing 

requirement in the proposed redemption fee rule, some plan record 

keepers that we spoke with explained that it would be inefficient to have 

transaction information of individual investors stored by both plan record 

keepers and fund transfer agents. Representatives of one mutual fund 

company told us that record keeping would be most efficient if 

intermediaries were only required to share transaction information about 

individual investors upon the request of mutual funds. 

The redemption fee proposal would also increase costs for fund 

intermediaries who would have to upgrade any systems that are currently 

unable to either transmit individual shareholder data to mutual fund 

companies or track transaction patterns of individual accountholders. 

Many intermediaries have stated that the costs of these technology 

upgrades would be substantial and would likely be passed on to mutual 

fund shareholders who invest through intermediaries, including pension 

plan participants. However, estimates of these costs depend to some 

extent on the flexibility of systems that intermediaries currently employ. 

Some fund intermediaries have argued that SEC should establish a 

uniform schedule for redemption fees in order to keep the cost of tracking 

the transactions of individual investors and assessing redemption fees to a 

minimum. Mutual fund company representatives, however, have told us 

that because funds vary in characteristics such as investment objective 

and investor turnover, funds have different needs for cost recovery and 

market timing deterrence. For example, an international fund might need 

higher redemption fee amounts and longer holding periods to discourage 

market timing. Therefore, they say, mutual fund directors should have the 

flexibility to set redemption fee terms that they feel would best achieve 

these goals and protect long-term investors. 
Page 26 GAO-04-799 Mutual Funds 

Pension plan record keepers note that SEC’s Hard 4 proposal would 

present complications for the processing of certain transactions that are 

unique to pension plans, such as participant loans, which are held by 

about 20 percent of 401(k) plan participants, according to three large plan 

record keepers.23 Record keepers told us that to process a loan request, a 

plan record keeper must know the value of the mutual fund shares held by 

the plan participant to determine how many shares must be redeemed, and 

from which funds, to meet the participant’s request and comply with 

various rules governing loan transactions. Currently plan record keepers 

process loan transactions after the net asset values of mutual fund shares 

have been calculated, which is after 4:00 p.m., and then submit a 

redemption order for a specified number of dollars or fund shares or a 

percentage of the participant’s total plan assets.24 Under the Hard 

4 proposal, record keepers would have to transmit redemption orders for 

loan transactions before they could know the net asset value of a 

participant’s shares in different funds; therefore, according to record 

keepers, they would likely use the prior day’s share prices to estimate 

either the number of shares to be redeemed or the amount of money to be 

withdrawn from each fund owned by the participant. Because mutual fund 

share prices usually change from one day to the next, the submission of a 

redemption order could result in either the participant receiving more or 

less money than requested or a violation of plan rules that specify the 

order in which shares may be redeemed. For example, many plans require 

participants to first redeem those mutual fund shares that were purchased 

with their own contributions before redeeming shares that were 

purchased with employer contributions. 

Figures 4 and 5 demonstrate the potential problems that may arise with 

loan transactions were the Hard 4 regulations to be adopted as originally 

proposed. 

 23A 401(k) plan is a common type of defined contribution pension plan sponsored by a 

private sector employer that generally allows a participant to make pretax contributions to 

an individual account. Earnings on contributions likewise accumulate tax-free until the 

funds are used. 

24Under Internal Revenue Code Section 72(p), a loan from a qualified plan to a participant 

or beneficiary will be treated as a taxable distribution, unless the loan amount is the lesser 

of $50,000 or one-half of the participant’s defined contribution account balance. 

SEC’s Hard 4 Proposal 

Could Complicate Certain 

Pension Plan Transactions 
Page 27 GAO-04-799 Mutual Funds 

Figure 4: Potential Complication with Loan Transaction if Dollar Amount Is Specified 

700.000 (700)

800.000 (800)

500.000 (2,500)

Money

source Fund

Estimated

shares to be sold

(Total shares held)

Actual

shares

sold

Previous

day's price

Actual

closing

price

Total

withdrawn

Total

withdrawn

Rollover

Employee

Employee

A

B

C

700.000 (700)

800.000 (800)

500.000 (2,500)

Estimated

shares

to be sold

(Total shares held)

700.000 (700)

800.000 (800)

500.000 (2,500)

20.00

$25.00

32.00

14,000

$20,000

16,000

14,000

$20,000

16,000

$50,000

Rollover

Employee

Employee

A

B

C

691.358

792.079

503.937

20.25

$25.25

31.75

(+.25)

(7.921) (+.25)

(-.25)

700.000

800.000

503.937

19.75

$24.75

31.75

(-.25)

(-.25)

(-.25)

(8.642)

(1,996.063)

(0.000)

(0.000)

(1,996.063)

$50,000

Rollover

Employee

Employee

A

B

C

$49,625

13,825

$19,800

16,000

X

Outcome

with

overall

dollar

increase

Outcome

with

overall

dollar

decrease 

Before

market

closes

After

market

closes

Estimate

Actual

When participant requests a 

$50,000 loan prior to the market 

close, the record keeper 

estimates the withdrawal based 

on the previous day's prices. 

Plan rules require that all 800 

shares of the money rolled over 

from a previous employersponsored plan be sold before 

contributions are distributed. 

Keeping the total amounts 

withdrawn from each money 

source constant, the record 

keeper cannot satisfy the 

withdrawal request and still 

adhere to plan rules. If share 

prices go up, plan rules may be 

violated. If share prices go 

down, then participant gets less 

than the amount requested.

Source: GAO.

(Shares

left over)

<

<

<

Plan rule violated (not all shares in fund were sold)

Participant receives less than requested (not enough shares available because of drop in price)

X

<
Page 28 GAO-04-799 Mutual Funds 

Figure 5: Potential Complication with Loan Transaction if Number of Shares Is Specified 

Despite SEC’s proposed measures to limit the application of the 

redemption fee, SEC’s redemption fee proposal may in certain 

circumstances penalize plan participants for certain transactions that 

could not be construed as attempts to engage in market timing. Plan 

participants do not control the timing of payroll transactions of fund 

shares, since plan sponsors and record keepers process these 

transactions. The transaction of purchasing fund shares in a participant’s 

plan does not necessarily occur on the same day that an employee receives 

a payroll deposit in the bank, and therefore plan participants may not 

know when additional fund shares are purchased on their behalf. 

SEC’s Proposed 

Redemption Fee Rules 

Could Impose Fees on 

Plan Participants when 

Not Intended 

Money

source Fund

Previous

day's price

Actual

closing

price

Estimated

total to be

withdrawn

Actual total

withdrawn

Estimated

total to be

withdrawn

Rollover

Employee

Employee

A

B

C

20.00

$25.00

32.00

14,000

$20,000

16,000

14,000

$20,000

16,000

$50,000

Rollover

Employee

Employee

A

B

C

19.75

$25.25

32.25

(-.25)

(+.25)

(+.25)

20.25

$24.75

31.75

(+.25)

(-.25)

(-.25)

$50,000

Rollover

Employee

Employee

A

B

C

$50,000

14,000

$20,000

16,000

13,825

$20,200

16,125

$50,150

$49,850

14,175

$19,800

15,875

Outcome

with

overall

dollar

increase

Outcome

with

overall

dollar

decrease 

Before

market

closes

After

market

closes

Estimate

Actual

When participant requests a 

$50,000 loan prior to the market 

close, the record keeper estimates 

the withdrawal based on the 

previous day's prices. Plan rules 

require that all 800 shares of the 

money rolled over from a previous 

employer-sponsored plan be sold 

before contributions are 

distributed. The record keeper 

may honor the plan rules by 

keeping the number of shares 

sold constant, but participant's 

request may not be met 

depending on the closing prices 

at the end of the day. 

Furthermore, if share prices 

increase, the withdrawal may 

exceed allowable maximum under 

the Internal Revenue Code.

Source: GAO.

X

X

Participant's request not met

Withdrawal exceeds IRS limit of $50,000

X

Estimated

shares to be sold

(Total shares held)

700.000 (700)

800.000 (800)

500.000 (2,500)

Estimated

shares to be sold

(Total shares held)

700.000 (700)

800.000 (800)

500.000 (2,500)

700.000 (700)

800.000 (800)

500.000 (2,500)
Page 29 GAO-04-799 Mutual Funds 

Occasionally plan participants rebalance the allocation of their plan assets 

among their different mutual funds, transfer retirement savings from one 

fund to another, or take a loan from their plan. In some cases, these 

participant-directed transactions may occur within 5 days of a payroll 

purchase of fund shares, and in some of these cases the plan participant 

would pay a redemption fee of 2 percent on the most recent payroll 

purchase of fund shares, despite the fact that there was no intent to 

engage in abusive market timing. The SEC’s proposed rule has attempted 

to address these situations by limiting the application of the redemption 

fee by (1) mandating a “first-in, first-out” method for determining 

redemption fees, (2) allowing funds to not collect redemption fees on 

proceeds of $2,500 or less (de minimis exception), and (3) limiting the 

rule’s holding period to 5 days, thereby targeting the most egregious 

circumstances of excessive trading.25 Nonetheless, some funds may choose 

not to apply the de minimis exception; therefore, in some cases, 

participants could still end up paying redemption fees. Usually, a 2-percent 

redemption fee on the last payroll purchase of fund shares would not 

amount to more than a few dollars. However, plan sponsors and 

administrators have argued that it would be unfair to penalize plan 

participants when there is clearly no intent to engage in abusive trading. 

Figure 6 illustrates how a plan participant could be assessed a redemption 

fee for transferring the balance of one fund to another. 

 25The first-in, first-out (FIFO) method would require that funds determine the amount of 

any fee by treating the shares held the longest time as being redeemed first, and shares held 

the shortest time as being redeemed last. According to SEC, use of the FIFO method would 

trigger redemption fees when large portions of an account are rapidly purchased and 

redeemed (a characteristic of abusive market timing transactions), but not when small 

portions of an account held over a longer period are redeemed. 
Page 30 GAO-04-799 Mutual Funds 

Figure 6: Assessment of a Redemption Fee for an Exchange Transaction 

Note: The proposed rule’s de minimis provision permits funds to forgo the assessment of a 

redemption fee if the value of the shares redeemed is $2,500 or less. 

In our most recent discussions, SEC officials told us that as of this writing, 

they are considering modifications to both the Hard 4 and redemption fee 

proposals to address the concerns cited above. SEC officials are also 

considering alternatives to the Hard 4 proposal (see app. II for discussion 

of two such alternatives) and are actively talking with mutual fund 

companies and fund intermediaries about the feasibility of these other 

options. 

Pension plans play a significant role in the financial markets of the United 

States as a primary vehicle for investing savings in the economy, and the 

use of mutual funds in pension plans often gives participants a great deal 

of choice about how they allocate their savings. Because late trading and 

market timing have negatively affected pension plan participants and other 

long-term investors, we support SEC’s efforts to stop these abusive 

practices. However, in certain circumstances, some pension plan 

participants may be more adversely affected by SEC’s proposed 

regulations than other mutual fund investors if they were to be adopted as 

proposed. Amending the proposed regulations to mitigate these potentially 

negative effects on pension plan participants, as SEC staff are now 

considering, seems a sensible approach. Without such changes, pension 

Conclusions 

1

Month 5

S M T W Th F S

Month 4

S M T W Th F S

Month 3

S M T W Th F S

Month 2

S M T W Th F S

Month 1

S M T W Th F S

Month 6

S M T W Th F S

20

11 1

Account

balance:

$200 $600 $800 $1,000 $400

$200

x.02

$4

-$1,200

A 2% redemption fee is assessed on 

the proceeds of any shares sold within

5 business days of purchase. For the sake

of simplicity share values remain constant.

Automatic $100 deposit at the beginning and middle of each month

Exchange made within 5 days of last deposit (2% redemption fee applied)

Source: GAO.

$1,200

-1,200

$0

15 15 16 15 15

2

+$200+$200

+$200

+$200+$200+$200

2

16
Page 31 GAO-04-799 Mutual Funds 

plan participants could face complications with certain transactions that 

are unique to pension plans and be assessed fees when they would clearly 

not be engaging in abusive trading. 

Given the significant role that mutual funds play in retirement savings, we 

are recommending that the SEC Commissioners adopt certain 

modifications or alternatives to the proposed regulations that are currently 

under consideration in order to prevent defined contribution plan 

participants from being more adversely affected than other investors. 

We provided a draft of this report to SEC and DOL. We obtained written 

comments from SEC, which are reproduced in appendix III. SEC agreed 

with our analysis and noted that the commission staff is considering 

modifications to the proposals that should mitigate certain circumstances 

that could adversely affect pension plan participants. SEC and DOL also 

provided technical comments, which we incorporated as appropriate. 

Unless you publicly announce its contents earlier, we plan no further 

distribution until 30 days after the date of this report. At that time, we will 

send copies of this report to the Commissioner of the SEC, the Secretary 

of Labor, appropriate congressional committees, and other interested 

parties. The report is also available at no charge on GAO’s Web site at 

http://www.gao.gov/. 

If you have any questions concerning this report, please contact me at 

(202) 512-7215 or George Scott at (202) 512-5932. Other major contributors 

include Gwen Adelekun, Amy Buck, David Eisenstadt, Lawrance Evans, 

Jr., Cody Goebel, Marc Molino, Derald Seid, and Roger Thomas. 

Barbara D. Bovbjerg 

Director, Education, Workforce, and 

 Income Security Issues 

Recommendations for 

Executive Action 

Agency Comments 
Appendix I: Objectives, Scope, and 

Methodology 

Page 32 GAO-04-799 Mutual Funds 

To determine how late trading and market timing have affected pension 

plan participants, we reviewed academic studies of how different types of 

mutual funds were affected by these trading abuses and compared this 

information with data about how defined contribution plan participants 

allocate their retirement savings among different types of funds. In 

addition, we asked various experts in the pension plan and mutual fund 

industries for any information about the effect of mutual fund trading 

abuses on pension plan participants. None of the representatives of 

pension plan record keepers,1

 mutual fund companies, and officials from 

the Securities and Exchange Commission (SEC) and the Department of 

Labor (DOL) were able to provide us an estimate of how late trading and 

market timing affected plan participants. 

We reviewed one study from 2003 on late trading, which estimated its 

effect on the values of mutual funds. We also identified seven studies done 

between 1998 and 2003 on market timing, four of which estimated its 

effects on the values of different types of mutual funds. We reviewed the 

methodologies used in these studies and found that they are consistent 

with techniques that are generally accepted in the academic literature. The 

estimates of the effects of late trading and market timing on long-term 

shareholders should be interpreted with caution because of data 

limitations, small samples that may not be representative of the mutual 

fund sector, and assumptions that underlie the estimates. However, we 

believe that these studies serve a useful purpose in providing a general 

sense of the scale of late trading and market timing. Furthermore, the 

variance in the results of these studies illustrates the difficulty of 

determining the extent and effects of late trading and market timing. 

To assess plan participants’ potential exposure to abusive trading 

practices, we obtained data from two large pension plan record keepers, 

two of the largest mutual fund companies (who are also plan record 

keepers), and the Investment Company Institute on how defined 

contribution plan participants allocate their retirement savings among 

mutual funds. The information about asset allocations to different types of 

mutual funds by plan participants was fairly consistent among these 

studies. We reviewed the methodologies used in these studies and the 

consistency of their data, and we found the studies to be sufficiently 

reliable for the purpose of describing the average allocations of pension 

assets of plan participants. 

 1

Plan record keepers include broker-dealers and insurance companies. 

Appendix I: Objectives, Scope, and 

Methodology 
Appendix I: Objectives, Scope, and 

Methodology 

Page 33 GAO-04-799 Mutual Funds 

To explain the regulatory actions taken by SEC and DOL to address late 

trading and market timing, we interviewed SEC and DOL officials and 

reviewed documents from both agencies. To describe SEC’s enforcement 

actions, we reviewed congressional testimony by SEC’s Director of 

Enforcement and press releases from SEC and the New York State 

Attorney General’s office and interviewed SEC officials. To describe new 

regulations either adopted or proposed by SEC, we reviewed the 

regulations and spoke with officials from SEC’s Investment Management 

Division who have been involved in writing these regulations. To describe 

DOL’s enforcement actions, we reviewed documents sent to us by DOL 

officials and interviewed these officials. To explain DOL’s guidance to plan 

sponsors on the duties of plan fiduciaries in light of mutual fund trading 

abuses, we reviewed the guidance issued by DOL and interviewed DOL 

officials. We also spoke with representatives of plan sponsors, plan record 

keepers, and mutual fund companies to obtain their opinions about DOL’s 

guidance. 

To determine how defined contribution plan participants and pension plan 

service providers might be affected by SEC’s rule proposals on late trading 

and redemption fees, we reviewed numerous comment letters submitted 

to the SEC. In addition, we interviewed representatives of mutual fund 

companies, pension plan record keepers, officials from the National 

Securities Clearing Corporation (NSCC), trade associations that represent 

mutual funds, plan sponsors, pension actuaries and life insurance 

companies, and officials from SEC and DOL. To assess how plan 

participants could be affected by an earlier deadline for the submission of 

mutual fund transactions, we reviewed information from plan record 

keepers and mutual fund companies about the types of mutual fund 

transactions that plan participants normally make during the course of a 

year. In addition, we obtained information about the mutual fund trading 

activity of plan participants in response to major events that resulted in 

significant increases or decreases in the values of major stock indexes. 

We conducted our work between March 2004 and June 2004 in accordance 

with generally accepted government auditing standards. 
Appendix II: Alternative Proposals to 

Eliminate Late Trading 

Page 34 GAO-04-799 Mutual Funds 

While many mutual fund companies and intermediaries support SEC’s goal 

of preventing unlawful trading in mutual fund shares, they have raised 

concerns about the Hard 4 proposal as a solution to illegal late trading and 

have suggested alternative solutions. These concerns center on the 

question of which entity or entities should be allowed to accept orders 

until the market closing time of 4:00 p.m. eastern time to receive the 

current day’s fund price. One alternative solution, the “Smart 4” proposal, 

seeks to maintain the flexibility intermediaries currently enjoy of 

accepting fund orders until the market close and then processing and 

transmitting them sometime after the market close. A second alternative, 

the “Clearinghouse” proposal, would require all mutual fund orders to 

receive an electronic time stamp at a central location that would verify 

their time of receipt. All orders received at the central clearinghouse by 

4:00 p.m. would receive same day pricing. 

The Smart 4 proposal would require all companies that want to accept 

orders until the market close, and process them thereafter, to adopt a 

three-part series of controls: (1) electronic time stamping of all 

transactions so all trades could be tracked from the initial customer to the 

mutual fund company, (2) annual certifications by senior executives that 

their companies have procedures to prevent or detect unlawful late 

trading and that those procedures are working as designed, and (3) annual 

independent audits. The Smart 4 proposal has been advocated by most of 

the fund intermediaries that we spoke with. Representatives of 

intermediaries told us that they should be given an opportunity to prove 

that they can comply with the same policies and procedures as mutual 

fund companies in accepting and processing fund orders. Furthermore, 

many intermediaries assert that while SEC’s Hard 4 proposal addresses 

intermediary processing of mutual fund orders, it does not go as far in 

seeking to prevent late trading at mutual fund companies. Currently, not 

all intermediaries are subject to SEC jurisdiction; therefore, under the 

Smart 4 proposal, any unregistered intermediary that forwards mutual 

fund orders to a fund company after the market close would have to 

consent to SEC inspection authority. However, SEC officials told us that 

they do not have the resources to examine the numerous unregulated 

intermediaries they would have to inspect to ascertain that adequate 

internal controls are in place to prevent late trading. To date, the Smart 4 

proposal has been revised a few times, and representatives of retirement 

plan intermediaries told us that they are working on developing a more 

robust network of controls that would allow independent auditors to 

verify that intermediaries are complying with the laws that prohibit late 

trading. 

Appendix II: Alternative Proposals to 

Eliminate Late Trading 
Appendix II: Alternative Proposals to 

Eliminate Late Trading 

Page 35 GAO-04-799 Mutual Funds 

The Clearinghouse proposal would require all mutual fund orders to be 

time-stamped electronically by an SEC-registered central clearing entity 

before the market close to receive that day’s fund price. The clearing 

entity’s time stamp would be considered the official time of receipt of an 

order for a mutual fund transaction. The National Securities Clearing 

Corporation is currently the only SEC-registered clearing agency operating 

an automated processing system for mutual fund orders.1

 The 

Clearinghouse proposal would expand the NSCC’s role, capabilities, and 

capacity to handle all orders of mutual fund transactions. Each mutual 

fund company and fund intermediary would consider its technological 

capabilities and other factors in deciding how to meet the requirement of 

submitting orders to the NSCC by 4:00 p.m. in order to receive same-day 

pricing. 

By requiring that all mutual fund transactions be processed through the 

NSCC, the Clearinghouse proposal seeks to ensure that companies that 

offer their own mutual funds do not gain an advantage over intermediaries 

that do not. By allowing record keepers to submit order information to the 

NSCC in two phases, the Clearinghouse proposal, like the Smart 4, would 

preserve the processing of fund transactions after the market close. First, 

before the market close, mutual funds and fund intermediaries would 

submit a fund order that must contain the information essential to 

establishing the customer’s intent.2

 Some orders would require additional 

information not essential to establishing intent. Under the Clearinghouse 

proposal, the additional information could be submitted after 4:00 p.m. as 

long as the submission establishing intent is received by the NSCC before 

4:00 p.m. 

One major concern surrounding the Clearinghouse proposal is that 

intermediaries who do not currently use the NSCC’s clearinghouse system 

may face significant costs in upgrading their computer systems and 

establishing a connection to the NSCC. SEC estimates that each year 

approximately half of all mutual fund orders are submitted directly to 

mutual funds through their transfer agents and the other half are 

 1

The NSCC is a not-for-profit organization. Investment companies that use NSCC’s 

clearinghouse service pay an annual membership fee plus 17.5 cents for each transaction 

they submit to the NSCC. 

2

The information required to establish intent includes the specification of the dollar value, 

amount, or percentage of fund shares to be transacted; whether the order is a purchase or 

redemption; identification information about the fund to be purchased or redeemed; the 

shareholder’s account number; and an order identification number. 
Appendix II: Alternative Proposals to 

Eliminate Late Trading 

Page 36 GAO-04-799 Mutual Funds 

submitted to funds through the NSCC. Intermediaries and funds that do 

not currently use the NSCC would have to either establish a direct 

communications link to the NSCC or make arrangements with other 

mutual funds or intermediaries who would be willing to transmit their 

orders to the NSCC on their behalf. Some pension plan record keepers are 

concerned that the costs of establishing a direct connection to the NSCC 

would be unaffordable. Another concern about the Clearinghouse 

proposal is that the NSCC may not be able to handle the concentration of 

orders it would receive just prior to the market close. However, the 

NSCC’s analysis indicates that its current system capacity is sufficient to 

handle the increase in transactions. Proponents state that a benefit unique 

to the Clearinghouse proposal is that it would allow plan record keepers 

and administrators to process plan participants’ requests for exchanges 

between different fund families on the same day. 
Appendix III: Comments from the Securities 

and Exchange Commission 

Page 37 GAO-04-799 Mutual Funds 

Appendix III: Comments from the Securities 

and Exchange Commission 
Appendix III: Comments from the Securities 

and Exchange Commission 

Page 38 GAO-04-799 Mutual Funds (130363) 
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