A somewhat rhetorical question, though I really am wondering whether I'm missing something.
Shares of a fund F (new position) are purchased (settled) without sufficient cash in the core account. The account is not marginable. The next day some of those just-purchased shares are sold to cover the purchase of those very same shares.
Stop and think about that for a moment. Then read on for details that may or may not matter:
These are house funds, so they settle immediately - one could do a same day exchange from one fund to another. There are in fact other house funds in the account with sufficient assets available to cover the purchase, as well as a brokerage agreement in place to permit using them for settlement.
However, the brokerage does not touch these assets. As far as cash flow is concerned, it appears these assets don't exist. The numbers of shares in the other funds never change.
Specifically, here's the sequence of transactions:
At start: $1,000 in core (transaction) account of brokerage account.
Core: $1,000
Fund F: $0 (no position)
Other Funds: $10,000
Settlement day S: The purchase of $5,000 of Fund F settles:
Core: $-4,000
Fund F: $5,000
Other Funds: $10,000
Day S+1: Brokerage sells $4,000 of fund F to cover deficit:
Core: $0
Fund F: $5,000 - $4,000 = $1,000
Other Funds: $10,000
Comments
Speaking only of my experiences at Fidelity, the original purchase could happen in my regular old taxable marginable brokerage account but would never fly in my non-marginable IRA account. In the IRA account if you don't have the funds they won't make the purchase. Interesting.
By regulation, brokers may not allow clients to purchase mutual funds on margin. However, once purchased and held as fully-paid for a period of 30 days, the mutual fund shares have loan value which may be used to extend margin credit against subsequent stock purchases.
Regards,
Ted
wtf? Since they ought not to have let the trade take place from the getgo, I would simply tell them you are going to document the entire thing to the various compliance entities.
Good point Ted. I forgot about that little nagging point.
The transactions occurred exactly as I described. One detail that I didn't include is that Fund F and (let's call it) Fund G in the "other funds" are MMFs. But they are position funds, meaning that like any other mutual funds they must be bought and sold, and they settle at close of market. They're not like checking accounts where the cash is just "there".
The original purchase order was okay - there were sufficient funds in G to cover the purchase. What should have happened is that Fund G should have been sold at the end of the day to settle the purchase of Fund F. Just as Fund G shares would have been sold at the end of the day to cover any check written against the brokerage account or to purchase an equity fund.
But Fund G wasn't sold, the core account went negative. As people are saying, this shouldn't have happened.
I believe the software got confused - it saw money market Fund F (albeit empty), and didn't move on to look at fund G for the cash. It couldn't place the sell order for F yet. So it stuttered, and placed the order the next day (after the shares showed up). It gave me a free ride for a day.
While the brokerage acknowledged that what happened was strange, it did not feel it needed to correct the transactions (though it is looking into its software). I do believe this was an honest error in an unusual situation. It is the unwillingness of financial institutions to acknowledge errors that is disappointing.
The next time your broker, your bank, your insurer, makes an error that could be reported to regulatory authorities, watch how they handle it. I'll bet you'll hear: "we can fix that". The rest of the sentence will be "because we're nice", not "because we were wrong". Then they hope you forget about it.
Interesting trivia I found when searching - the reason that mutual fund shares are not marginable for 30 days is that they are considered new issues, and newly issued securities have that 30 day waiting period.
Which begs the question - what about ETF shares that AP just purchased? Shouldn't these particular shares (not all ETF shares) also be subject to a 30 day requirement. If so, how do you know whether you've got some of these newly minted shares when you buy them on the open market?
Actually, the rule didn't apply here. Had the account been marginable (I double checked - it was not), then the other funds ($10K) could have been used to get $5K in cash - enough to purchase fund F.
Well now I flummoxed up good. At another brokerage I use (IRA account) I cannot sell a mutual fund to purchase another from a different family on the same day. Nothing new here, I think we all pretty much know this. However, in order to make the purchase the sell transaction has to 'clear' which could mean a delay of anywhere between 1-3 days. Maybe there are different rules for taxable vs. non, IRA vs. regular, MMF's vs. other types of funds, in-house funds vs. the other kind and so on and so forth.
I hear what you say about mistakes and errors however.
Mutual funds through brokerages generally settle in one day, though a fund family can process an exchange on the same day. Many other securities (e.g. stocks, ETFs, CEFs, etc.) that go through exchanges settle in three days.
This discrepancy is why I turned off margin in my account years ago. I sold an ETF and purchased a mutual fund. I had expected the money from the ETF to be used to settle the mutual fund purchase. Because it took 3 days for the ETF to settle (i.e. to get the cash), but I had to pay for the mutual fund in 1 day, I wound up borrowing the money (margin) for two days.
Had the account been a cash account (no margin) the broker wouldn't have let the trade go through. (Well, unless it did something weird like the broker I started the thread with.)
When you buy a mutual fund directly from the fund company, it settles immediately. The distributor issues you the shares when it gets the money (e.g. you authorize debiting your bank account). My impression is that brokerages handle their in-house funds the same way, e.g. Fidelity brokerage and Fidelity funds. There's no one day delay. But this is just an impression. The rest of what I wrote (T+1, T+3) is certain.
See, e.g. Fidelity: https://www.fidelity.com/learning-center/trading-investing/trading/trading-differences-mutual-funds-stocks-etfs
Edit: The only time I've seen T+3 for mutual funds is when I traded a mutual fund at a brokerage that didn't work directly with the fund family. In a sense the broker had to "hand carry" the order to the fund. If you ask the broker about a particular fund, they should be able to tell you whether it is T+1 or T+3.
http://www.investopedia.com/terms/o/overdraft.asp
That's a good word to describe to the negative core balance. The question is, was the loan proper?
It wasn't a loan in the traditional sense (margin, use of money for interest, etc.). It doesn't quite fit the definition of kiting (at least no intent on my part, and I was the beneficiary of the free ride). Did I get an unsolicited gift (interest free loan for the purpose of purchasing securities)?
The brokerage goofed (operational error). I agree it was an "honest" error. Though the brokerage has not acknowledged error, honest or otherwise.
Does the nature of the error make the transaction okay? "But officer, I never saw the stop sign ..."
Etfs are marginable, maybe already pointed out.
Once you own shares of FCNTX for 30 days, they become eligible to borrow against ("margin"). You're free to borrow (up to certain limits) against those shares and get cash. What you do with that cash (buy more shares, put a down payment on a house, whatever) is your business.
There's another way to use margin when purchasing securities. You can use the securities that you're about to purchase as collateral to make the purchase itself. I believe that this is limited to 50% of the value - so if you're buying $100 of an etf, you need only put up $50. You borrow the other $50 against the $100 value of the etf.
This form of margining is what you can't do with mutual funds. You can't borrow against those shares of FCNTX that you're about to buy. If you want to buy $100 of FCNTX, you have to put up $100 in cash. But that cash can come from borrowing against older shares of FCNTX that you also own.
See, e.g. Nasdaq (Zacks commentary):
http://www.nasdaq.com/article/using-mutual-funds-for-securities-lending-margin-loans-mutual-fund-commentary-cm408896
"Investors can take a [margin] loan to buy more stocks or mutual funds."
This time the error was on an ETF, where it spun off $X in dividends, and the brokerage automatically "reinvested" $X+1. This triggered an instantaneous margin call.
On the plus side, this brokerage acknowledged the error quickly when phoned, said they were aware of it, and they were fixing the problem. On the minus side, when one logs in (more than a full trading day after the glitch), there's still a big bright margin call warning. No email notice about a margin call, and I had to call them to find out that it was being addressed.
I'm now wondering how brokerages handle dividend reinvestments. I believe they pool all their clients' dividends, purchase shares on the open market (or out of inventory), and then split into fractional shares on their books. It doesn't seem to be that hard to get it right - whatever price they purchase the shares for is the price that they charge each client.
My mind is now drifting back to the movie WestWorld, "what could possibly go wrong?"
Supposedly this is how Fidelity does it however the outcome is never predictable much like opening Forrest Gumps box of chocolate. Logically, if one reinvests the dividend, one expects that they will receive additional shares at the previous days' closing price minus the dividend but they would be wrong. Not even close, even with a bond fund (CEF).
Yet here we have a brokerage that didn't get it right. I can see minor difficulties for the brokerages, but if they're offering the service, they should be eating the costs:
1. Brokerage adds up all dollars from all investors reinvesting. Exact calculation.
2. Brokerage tries to buy number of shares that match dollar amount - Approximate result, because order is placed for a specific number of shares. This seems to be the fly in the ointment.
If the order is placed as a market order, the brokerage may wind up with cash left over (necessitating a follow up order), or may have to pay more money than the shareholders are reinvesting (brokerage eats cost? or charges margin???)
If the order is placed as a limit order, the brokerage risks not filling the order (and then placing order at a higher price, costing the investors money). Or the order may be filled at a lower price, resulting in excess shares (broker carries as inventory?).
3) Brokerage then divides shares on books among investors. Exact calculation, but leaves a fraction of a share (petty cost to brokerage, adds fraction to inventory?).
I could see an error being made if the pool of shares were purchased in multiple transactions and the costs weren't prorated correctly among the reinvesting investors. Regardless of the origin of the error, it seems that it ought to be something already anticipated and programmed for.
That's why I'm wondering how this whole process actually works.
@msf- Interesting questions... can't say that I ever thought about it. Do all brokerages do it the same way? I can see the issues that you describe if the brokerage keeps a common pool for all investors in a particular fund. Is it possible that a brokerage would have an arrangement where they have a master account at a given fund, but that master account would be subdivided into individual accounting entries? In that kind of setup the individual entries could simply be numbered line items, without the fund needing to know any information about the actual customer. It would be up to the broker to match each line item to the actual brokerage customer's account.
In such an arrangement the dividend shares would simply be added by the fund to each line entry, and the brokerage wouldn't be involved in any of the messiness.
ETFs are different. They're more like stocks - you don't hold an account with the fund (unless you're an Authorized Participant), you just deal with the open market. But the bookkeeping on the brokerage side is similar - all the shares are in "street name" (i.e. the brokerage has legal title), and the brokerage ledger keeps track of who really owns what.
Here's a thread from elsewhere that describes pretty much the same thing. It's got links to TDA and E*Trade's div reinvestment programs. What they doesn't address is how the brokerage gets the number of shares right.
http://money.stackexchange.com/questions/54380/how-do-dividend-reinvestment-purchases-work