The shortest trading interval that most ordinary investors (as opposed to high frequency trading firms) consider is daily – primarily because many mutual funds can be traded with little or no trading costs at the end of each trading day. With most funds an investor can instruct their investment company to buy or sell a position in an ordinary no-load mutual fund at its end-of-day net asset value with little or no trading costs – although most investment companies limit trading that they consider to be excessive. The per share net asset value of a fund is simply the value of all the assets underlying the fund divided by the number of shares that investors own in that fund.
In previous decades there were many mutual funds that consistently mispriced their net asset values each day because the funds held international stocks (traded in time zones such that the closing market prices were many hours old) or held assets such as real estate that were valued based on slowly-changing appraisals. When investment companies mispriced the assets underlying their funds, their daily net asset values were often too high or too low. The mispriced net asset values made market timing very easy and very profitable.
The easiest market-timing strategy was an international mutual trading strategy that involved switching to international funds at the close of each U.S. trading day when the U.S. market had risen during the afternoon (after foreign markets closed) and switching out of international funds on other days. The next day, after buying into the international mutual fund, the foreign markets would tend to “catch up” to the previous day’s afternoon movements in the U.S. market. The strategy was enormously profitable and it led to important improvements in the way that mutual funds priced their portfolios as well as to tighter controls on daily trading that could harm other investors.
Another popular mutual fund trading strategy was slower than daily and involved the subset of funds that held illiquid assets such as direct real estate. Investment companies valued these funds at appraised values – which were changed infrequently and lagged seriously behind real estate price movements. Shrewd investors would jump into these funds a few months after real estate prices began to boom and bail out of the funds as soon as real estate collapsed. Due to the fund’s lag in adjusting its price (net asset value) the strategy was very successful.
Improved valuation methods of investment companies and trading restrictions have severely reduced the advantages of these types of strategies based on mutual funds trading. Further, high frequency trading firms have made short-term trading of stocks and exchange-traded funds nearly impossible for ordinary investors. While this is disappointing to prospective traders, it is good news to the economy in general because it means that the prices of financial assets are tending closer and closer to their true underlying values.
The remaining parts of this series focus on longer term equity market timing.