Why T. Rowe had to ban the American Airlines traders

American Airlines at JFK International Airport.
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American Airlines at JFK International Airport.

The move by mutual fund manager T. Rowe Priceto ban 1,300 American Airlines employees from trading in four of its funds has been greeted with howls of outrage from those banned.

Even some who aren't shut out raised an eyebrow at encountering the rarest of rare beasts: a mutual fund manager turning away investor dollars.

But far from being a great injustice or even a sudden failure of the avarice organ of T. Rowe Price's fund managers, the move to terminate the trading rights of those American Airlines employees is actually a sign that the firm is looking out for its customers.

What appears to have happened is that some 1,300 of about 74,000 American Airlines employees involved in the companies savings plan were trading on the advice of a company called EZTracker, a subscription service that gives advice to airline employees about their investment funds. There's nothing illegal about this. People trade on the opinions of outside investors all the time.

But these trades were viewed as disruptive by T. Rowe Price—so it moved to shut them down.

To understand why, it helps to start by seeing that mutual funds that invest in assets that are not very liquid face the risk of something like a bank run.

If enough investors suddenly decide to exit a mutual fund, the fund's managers may be forced to sell assets to meet the redemption demand. When the assets are somewhat illiquid, the forced sale may push down the prices of the assets. If the redemptions are large enough, prices could move a good deal away from the fundamentals.

Hedge funds deal with this problem by requiring notice periods for redemptions. These allow hedge fund managers to sell assets slowly over a period of weeks or even months, and to wait for advantageous market conditions to sell.

Some even allow managers to ban redemptions for a period of time if they believe asset prices are particularly unfavorable at the time.

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This isn't a strategy available to mutual fund managers.

Mutual funds are required by law to offer investors daily liquidity (except in certain market emergencies, when they can hold back redemptions for as long as a week). If you want to exit your investment, a mutual fund has to give you cash equal to your proportionate share of the net asset value of the fund right there and then.

Generally, the fire-sale scenario is avoided by mutual funds by having some cash on hand and by the orderly flow in investors into and out of the fund. As long as the redemptions are more or less balanced with the inflow of new investments, everything works out just fine.

Which is to say, mutual funds aren't really built to handle the collective trading that the EZTracker newsletter seems to have inspired among 1,300 American Airlines employees. Mass exits have the potential to throw a mutual fund off-kilter, forcing sales of assets at undesirable prices.

Because mutual funds are also required to calculate their net asset values daily, the forced sales drive down the value of the fund overall.

And because the assets aren't very liquid, there might be a long delay before trades occur that would allow the fund managers to write them back up to their fundamental value. This can create the impression that the assets are fundamentally or permanently impaired, which might scare other investors into selling, digging the valuation hole even deeper.

Long-term investors in the fund, obviously, would see their investments at least temporarily impaired and, to the extent they panic at seeing their NAVs fall and sell at depressed prices, would suffer permanent damage.

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Notice that distortions are made even worse if the investors trading collectively also act en masse when buying. In that case, the mass buying might push the illiquid assets values up, forcing the fund to buy at higher prices. This would make the move on exit even more exaggerated.

T. Rowe Price's policy of excluding investors who want to engage in collective trading is a way of protecting the buy-and-hold investors. It's akin to policies that most mutual funds have adopted to protect investors from "market timers" who seek to exploit stale prices that can make a fund's assets temporarily over- or under-valued.

The publishers of EZTracker argue that the practice is "discriminatory"—which is certainly correct.

It discriminates against those who trade in ways that potentially damage the long-term investors, in just the same way that anti-smoking laws discriminate against smokers. By taking this action, T. Rowe Price is defending its business model and the interests of those who believe in it against those who don't.

This shouldn't be shocking.

T. Rowe Price, like most mutual funds, explains in the prospectuses for their funds that they aren't intended for excessive trading and that they can suspend or terminate the investment privileges of anyone who trades excessively.

In T. Rowe Price's case, it specifically mentions trading in connection with newsletters as something that can get you tossed out. In fact, they tout this as something they do to protect the integrity of the funds.

What's more, many of the 1,300 who were tagged with a trading ban had ample warning. T. Rowe had placed restrictions on them earlier, cautioning them that the practice was against the fund rules.

T. Rowe Price can't turn its back entirely on the 1,300 American Airlines employees. Those who have money invested in the funds can still pull their money out.

All 1,300 can still make regularly scheduled contributions into the T. Rowe Price funds. They just can't exchange money from the other funds in their savings accounts into T. Rowe Price's funds.

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