Mutual Fund Arbitrage and Transaction Costs

Abstract

The 2003 mutual funds scandal that exploded upon the public revealed something that had long been known
to insiders: Mutual fund advisers often approve and allow frequent trading, frequent trading arbitrage, and late trading arbitrage to selected traders. To increase adviser profits, fund advisers often require approved arbitrage traders to make “sticky asset” purchases of fund shares to “grow” fund assets. These costly mutual fund adviser practices increase transaction costs along several dimensions and lower current fund and shareholder assets, along with opportunity costs of dilution in fund share values and returns to long-term shareholders. Independent directors have either not been informed or have acquiesced in the decisions. In any case, independent directors have not performed their primary fiduciary duty as “shareholder watchdogs.”

Full text

Electronic copy available at: http://ssrn.com/abstract=1419739
SUMMER 2009 THE JOURNAL OF INVESTING 57
“There is no hard line between arbitrage
and speculation: it is a continuum.”
—Stephen A. Ross,
Franco Modigliani Professor
of Finance and Economics,
Sloan School of Management, MIT.
T
he Investment Company Act of
1940 (40Act) has not provided
essential protections for mutual fund
shareholders. Palmiter [2006] finds
that the 40Act’s “outsourcing” of key regulatory
functions to independent directors of funds has
also not lived up to the act’s expectations. These
independent directors have been weak and even
feckless protectors of fund shareholders and are
therefore not sufficiently aligned with share-
holder interests. The one thing dedicated inde-
pendent directors can do is perform as
effectively as possible given the act’s limitations.
The 40Act’s reliance on what has proven
to be insufficiently empowered mutual fund
independent directors is the most serious imped-
iment to effective oversight of fund advisers.
The 40Act does not give the SEC the task of
reviewing approvals by mutual fund indepen-
dent directors of management contracts and
marketing arrangements, but rather relies on
independent directors to oversee fees of fund
advisors and those of other service providers,
such as transfer agents. The SEC has also not
provided essential tools and disclosures that inde-
pendent directors need to be more effective.
By all logic, the 2003 mutual fund scan-
dals were not “out of the blue,” but rather just
one, though a major, event in the pattern of
industry malfeasance toward shareholders that
has been seen in recent decades. Such behavior
was not anticipated under the 40Act, which
the fund industry has long “advertised” as
effectively protecting shareholder interests. The
claim was that under the act and SEC regula-
tion, there have been only a limited number
of individual fund scandals.
Then, in 2003, the fund industry’s
ongoing “rosy scenario” came to an abrupt
end, thanks to one brave mutual fund adviser
employee and an aggressive New York attorney
general. The scandal that exploded upon the
investing public revealed improper actions that
have long been well known to insiders. One
such behavior is advisers allowing market
timing in fund shares, which includes frequent
trading, frequent trading arbitrage, and late-
trading arbitrage. “Market timing” is rapid
roundtrip trading in fund shares made to
exploit pricing inefficiencies (mispriced shares).
Advisers with stated limits on frequent trading
in their prospectus also engage in this behavior.
Those mutual fund advisers who stated
limits on share redemptions would logically
not have done so if they knew frequent trading
was harmless to long-term shareholders. Why
place limits on redemptions? And, those
advisers who permitted frequent trading arbi-
trage (with or without stated limits) certainly
Mutual Fund Arbitrage
and Transaction Costs
JOHN A. HASLEM
JOHN A. HASLEM
is professor emeritus of
finance in the Robert H.
Smith School of Business at
the University of Maryland
in College Park.
jhaslem@rhsmith.umd.edu
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knew the practice profited them and harmed long-term
shareholders.
FREQUENT TRADING
Frequent trading is roundtrip “rapid trading” with
short holding periods by new and current mutual fund
shareholders. Investors often buy and sell based on short-
term forecasts of market or company developments. Rapid
trading is often limited in the prospectus to a set number
of roundtrip trades a year. Other funds work to limit fre-
quent trading by policy, monitoring, and redemption fees
for short-term trades.
Frequent trading presents a regulatory challenge
because it imposes higher transaction costs than do the
infrequent trades of long-term mutual fund shareholders,
but this higher cost is a matter of degree, not kind. The
issue is not just whether some fund investors trade more
frequently than others (and impose higher costs), but
whether there is a point at which subsidization of frequent
traders by long-term shareholders becomes egregious and
calls for regulatory reform. That point has been reached.
Mutual fund advisers are not required to limit fre-
quent trading, but if they do the limits must be stated in
the prospectus. For example, one fund’s prospectus states:
“You may not exchange your investment more than four
times in any 12-month period ….” While many advisers
state limits, frequent trading has been approved and allowed
for select frequent traders.
In some cases, mutual fund advisers attempted to hedge
their stated limits on frequent trading by making them appear
as discretionary or only implied. For example, it might be
stated that frequent trading is “generally” limited, or that
“short-term” or “excessive” trading is not allowed. The
“catch” is in how advisers then interpreted these limits when
approving and allowing frequent trading to select traders.
In such cases, reference to internal documents may be needed
to determine the adviser’s real intent, but lack of shareholder
access is the problem. Another approach to determining the
adviser’s real intent is to assess how reasonable shareholders
would interpret their hedged statements.
It is useful to think of frequent trading and frequent
trading arbitrage (discussed below) as differing only in
that the latter generates larger mutual fund transaction
costs and lower current fund and shareholder assets, along
with opportunity costs of dilution in fund share values
and returns for long-term shareholders. The practice of
frequent trading (and frequent trading arbitrage) in funds
was widely known in the industry and to the SEC well
before the fund scandals were revealed.
FREQUENT TRADING ARBITRAGE
Approval and allowance of frequent trading arbi-
trage represents a major conflict of interest between mutual
fund advisers and shareholders. While fund advisers are
directly responsible for this practice, independent direc-
tors have failed to protect shareholder interests. But if
advisers do not inform independent directors of their
intentions, the burden rests with them.
In some cases, independent directors apparently
acquiesced when informed of the adviser’s decision to
allow frequent trading arbitrage. These directors were
often long-time friends and “golfing buddies” of the
adviser CEO, who often lack sufficient commitment,
expertise, and qualifications to protect the primary inter-
ests of shareholders. In addition, any independent director
tendencies to “go with the flow” might well be con-
sciously or subconsciously encouraged by their generous
pay and benefits. The lack of independence of “inde-
pendent” directors is an open secret in the funds industry.
But independent directors owe shareholders legal pro-
tections and comprehensive disclosure.
Despite the mutual fund scandal and SEC pressure,
fund advisers generally have not taken action to ensure that
fund closing prices reflect current market prices. Such
action would prevent profitable frequent trading arbitrage,
with larger transaction costs, lower current fund and share-
holder assets, and opportunity costs of dilution in fund
share values and returns for long-term shareholders.
This action requires that mutual fund holdings of for-
eign securities that close trading overseas before the domestic
4:00 p.m. market close be priced at the 4:00 p.m. close. To
do this, a valid and uniform “fair value” pricing system must
be applied to estimate the 4:00 p.m. closing values of for-
eign securities and securities without current market prices.
This inaction by many mutual fund advisers provides
a major conflict with shareholder interests. Frequent trading
arbitrage with larger transaction costs has lower current
fund and shareholder assets, along with opportunity costs
of dilution in fund share values and long-term shareholders.
These are not appropriate costs to long-term shareholders,
especially because they are not normally aware of them or
of their surprising costs. Further evidence of agency con-
flict is seen in the negative relation between dilution and
both expense ratios and number of insider board members.
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Mutual fund shareholders still await effective pro-
tection from frequent trading and late trading arbitrage.
However, it does not appear that arbitrage is high on the
SEC’s list of needed regulatory reforms. For example,
then-New York Attorney General Spitzer was first and
much more aggressive than the SEC in prosecuting
wrong-doers, as witnessed by the much larger amounts
won in direct and indirect damages.
TIME ZONE FREQUENT TRADING
ARBITRAGE
Time zone arbitrage is made possible by several
mutual fund, adviser, and market characteristics and actions.
First, fund shares traded during the day are priced at the
4:00 p.m. close of trading, which is called “forward pricing.”
Second, the fund’s holdings of securities trading on Asian
exchanges, for example, are priced at their 3:00 a.m. Eastern
closing price when fund securities are priced at the
4:00 p.m. close. Third, prices of the foreign securities must
increase after their 3:00 a.m. Eastern close, but before the
fund’s 4:00 p.m. close. This price increase is caused by an
arbitrage event, such as announcements of expectedly high
earnings for the foreign securities. Fourth, the fund does
not use these increased prices to price the foreign shares
at the 4:00 p.m. close, but rather uses their 3:00 a.m. Eastern
closing prices at the close. The result is that fund shares are
not priced at their current market values at the 4:00 p.m.
close. Arbitrager share purchases during the trading day
are therefore priced at “discount prices” at the close. Fifth,
fund advisers allow arbitragers to “rapid trade” by per-
mitting them flexibility in holding periods (usually short
ones, such as one trading day) and frequency of roundtrip
trades (usually ongoing). Rapid trading allows arbitragers
to generate abnormal assets over very short periods of
time. Frequent trading also reduces arbitrager risk by aver-
aging the outcomes of individual roundtrip trades.
Frequent trading arbitrage thus involves the purchase
of mutual fund shares at “stale” closing prices below their
current market values. Arbitragers do not create the oppor-
tunity to buy fund shares at bargain prices, but by their
actions they attempt to take advantage of share mispricing.
MECHANICS OF TIME ZONE FREQUENT
TRADING ARBITRAGE
An example by Bullard [2006] of the mechanics of
frequent trading arbitrage indicates how dilution occurs
and dollar amounts. As discussed, arbitrage trading involves
buying fund shares priced below their current market
value at the close of trading. Arbitrage trades are often
made in funds holding securities trading on Asian
exchanges, which close at 3:00 a.m. Eastern. The fund
uses the 3:00 a.m. Eastern closing prices of the Asian secu-
rities when it prices all securities at the 4:00 p.m. close.
Arbitragers can then sell the fund shares at a profit the
next trading day, when the current market prices of all
fund securities will be incorporated into the 4:00 p.m.
closing prices, all else remaining the same.
An example of the mechanics of time zone arbi-
trage provides insight on the amount of dilution created
by one such arbitrage roundtrip trade. To illustrate this
process, assume there are nine mutual fund shareholders
holding one share each. These nine shares are each priced
at $10.00 at the 4:00 p.m. closing and provide a fund total
value of $90.00. At the 4:00 p.m. close, the fund’s share
price reflects the 3:00 a.m. Eastern closing prices of its
foreign securities holdings, but not the arbitrage event’s
subsequent increase in prices of these securities following
their 3:00 a.m. Eastern close. That same day, arbitragers
note the price increase in the fund’s holdings of Asian
securities and purchase one fund share priced at $10.00
at the close. The fund’s total value is now $100.00 with
10 shares. However, the fund’s total market value based
on the arbitrage event is actually $110.00, or $11.00 per
share, at the 4:00 p.m. close.
The next day, the current market prices of the fund’s
foreign securities are included in its 4:00 p.m. closing price
of $11.00, all else having remained the same. That same
day, the arbitrager redeems his fund share at the closing
price of $11.00. This redemption reduces the fund’s arbi-
trage-event total market value of $110.00 to $99.00. The
arbitrager’s share with a cost basis of $10.00 sold for $11.00
and generated an arbitrage profit of $1.00.
The fund’s stale total closing price of $100.00 on
day one has gone to a current total closing price of $99.00
on day two. The current loss of $1.00 in fund and share-
holder assets approximates $0.11 per share, along with
opportunity costs of dilution in fund share values and
returns for long-term shareholders.
LATE TRADING ARBITRAGE
Late trading arbitrage can occur when mutual fund
advisers illegally approve and allow selected traders to pur-
chase fund shares after the market close, but priced at
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4:00 p.m. closing prices. This opportunity allows traders
to take advantage of “arbitrage events” in fund portfolio
prices that occur after the 4:00 p.m. close. Traders then
buy shares at what are after the 4:00 p.m. close effectively
discounted closing prices, and then sell the shares soon
thereafter for abnormal profits. Arbitrager profits are earned
at the expense of current fund and shareholder assets,
along with opportunity costs of dilution in fund share
values and returns for long-term shareholders.
Mutual fund adviser allowance of late trading arbi-
trage represents a serious unethical and illegal conflict of
interest with fund shareholders. Fund advisers are directly
responsible for approving and allowing this egregious prac-
tice, and independent fund directors have failed to halt it.
But, if independent directors are uninformed, due to no fault
of their own, then the burden rests fully with fund advisers.
However, there are cases where mutual fund advisers
may not be aware of late trading of their fund shares. Tra-
ditionally, advisers have attempted to limit late trading
only through fees and monitoring, but late trading is often
“hidden” in the total of fund trades executed by financial
intermediaries, such as brokerage firms. Financial inter-
mediaries have traditionally “packaged” late trades and
reported them to funds after the 4:00 p.m. close. Efforts
to require all such trades to be reported by a “hard”
4:00 p.m. close should keep advisers informed of fund
late trading allowed by financial intermediaries.
The costs of late trading arbitrage are not inconse-
quential. Following the 2003 mutual funds scandal, Zitze-
witz [2006] found late trading was three times greater in
fund families charged for late trading, and greater in funds
and asset classes that also received heavy “stale price” fre-
quent trading arbitrage inflows. Further, evidence of late
trading arbitrage was statistically significant in 39 out of
66 fund families, and this trend has been corroborated
subsequently by regulators. Late trading arbitrage was
found to be a “stand-alone” strategy, but always paired
with frequent trading arbitrage.
Late trading diluted average annual assets of long-
term shareholders in international and domestic equity
funds by 3.8 and 0.9 basis points, respectively. If similar
dilution rates prevailed in the funds industry, shareholder
losses would be $400 million per year. Initially, this finding
shocked fund observers, but it is a small figure compared
to losses from frequent trading arbitrage.
However, mutual fund shareholder losses from late
trading arbitrage are smaller than those in “soft dollar”
trades. These trades have very high brokerage commissions
and likely higher trading costs, and are often excessively
transacted to benefit brokers and advisers. Brokers partially
rebate their soft-dollar trade commissions to advisers in the
form of in-kind payments of investment products and ser-
vices. Soft-dollar trades reflect important adviser agency
conflicts with shareholders and deserve regulatory reform.
FREQUENT TRADING AND LATE TRADING
ARBITRAGE: SHAREHOLDER IMPLICATIONS
Mutual fund independent directors have the pri-
mary legal responsibility of representing shareholder inter-
ests as primary. However, when advisers fail to inform or
to seek approval of independent directors for approval of
frequent trading arbitrage (the discussion in this section
applies also to late trading arbitrage), directors are not able
to perform their mandate as “shareholder watchdogs.”
The mutual fund adviser may provide selected large-
size frequent trading arbitragers with more frequent port-
folio information than is provided to long-term shareholders.
The improper sharing of this information distorts normal
fund management and strategies. The practice may lower
current fund and shareholder assets, along with opportunity
costs of dilution in fund share values and returns for long-
term shareholders.
Mutual fund advisers, by not informing indepen-
dent directors of the approval and allowance of large-size
frequent trading arbitrage, also fail to report frequent
trading to the SEC. And, neither do advisers disclose these
transactions to long-term shareholders, which defers them
from possibly selling their shares. Frequent trading arbi-
trage with larger transaction costs requires larger cash
holdings with lower current fund and shareholder assets,
along with opportunity costs of dilution in fund share
values and returns for long-term shareholders.
Mutual fund advisers’ allowance of especially large-
size frequent trading arbitrage requires larger and more fre-
quent purchases and sales (turnover) of portfolio securities
to meet trader transactions. These larger trades distort
normal fund management and strategies, and possibly
create additional fund trading errors. The resulting higher
costs lower current fund and shareholder assets, along with
opportunity costs of dilution in fund share values and
returns for long-term shareholders.
Mutual fund advisers’ allowance of especially large-
size frequent trading arbitrage also requires additional
administrative mechanisms (by all parties to arbitrage
capacities) that include processing, capacity negotiations,
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communications, record-keeping, and account monitoring.
These higher costs also lower current fund and shareholder
assets, along with opportunity costs of dilution in fund
share values and returns for long-term shareholders.
Mutual fund adviser fee payments to “facilitator bro-
kers” who negotiate and arrange frequent trading arbitrage
“capacities” with large traders increase fund costs. These
higher broker costs lower current fund and shareholder
assets, along with opportunity costs of dilution in fund
share values and returns for long-term shareholders.
The mutual fund adviser normally requires frequent
trading arbitragers to provide “sticky assets” with their
timing capacities. These requirements increase fund assets
(often in funds with high expense ratios) and increase cur-
rent fund and shareholder assets, along with larger fund
share values and returns for long-term shareholders.
However, larger mutual fund transactions from fre-
quent trading arbitrage increase trade size and increasingly
subsume fund economies of scale from increasing asset size.
This occurs when the size of trades goes beyond recouping
trading costs. Edelen, Davis, and Kadlec [2007] find that
the scale effects of increased trade size are the primary cause
of subsuming mutual fund economies of scale. This nega-
tive impact on fund assets is not hard to understand, with
transaction costs frequently exceeding expense ratios.
Mutual fund advisers’ allowance of especially large-
size frequent trading arbitrage generates larger and more
frequent fund purchases and sales of portfolio securities
(higher turnover) to meet trader transactions. The larger
and more frequent trades have a negative impact on share-
holder taxes, with larger taxable capital gains distributions
to long-term shareholders and lower after-tax assets.
For additional insights into the issues discussed, see
Birdthistle [2006], Bullard [2006], Edelen, Davis, and
Kadlec [2007], Gil-Bazo and Ruiz-Verda [2008], Greene
and Ciccotello [2006], Haslem [2008], Palmiter [2006], and
Zitzewitz [2003 and 2006].
CONCLUSION
The 2003 mutual funds scandal that exploded upon
the public revealed something that had long been known
to insiders: Mutual fund advisers often approve and allow
frequent trading, frequent trading arbitrage, and late trading
arbitrage to selected traders. To increase adviser profits, fund
advisers often require approved arbitrage traders to make
“sticky asset” purchases of fund shares to “grow” fund assets.
These costly mutual fund adviser practices increase
transaction costs along several dimensions and lower cur-
rent fund and shareholder assets, along with opportunity
costs of dilution in fund share values and returns to long-
term shareholders. Independent directors have either not
been informed or have acquiesced in the decisions. In any
case, independent directors have not performed their pri-
mary fiduciary duty as “shareholder watchdogs.”
REFERENCES
Birdthistle, William A. “Compensating Power: An Analysis of
Rents and Rewards in the Mutual Fund Industry.” Tulane Law
Review, 80 (2006), pp. 1401–1465.
Bullard, Mercer E. “The Mutual Fund as a Firm: Frequent
Trading, Fund Arbitrage and the SEC’s Response to the Mutual
Fund Scandal.” Houston Law Review, Vol. 42, No. 5 (Spring
2006), pp. 1271–1332.
Edelen, Roger M., Richard B. Davis, and Gregory B. Kadlec.
“Scale Effects in Mutual Fund Performance: The Role of
Trading Costs.” Working Paper, SSRN, March 17, 2007.
Gil-Bazo, Javier and Pablo Ruiz-Verda. “The Relation Between
Price and Performance in the Mutual Fund Industry.” Working
Paper, SSRN, March 3, 2008.
Greene, Jason T., and Conrad S. Ciccotello. “Mutual Fund Dilu-
tion from Market Trading Trades.” Journal of Investment Man-
agement, Vol. 4, No. 2 (First Quarter 2006), pp. 36–54.
Haslem, John A. “Mutual Funds: Why Have Independent Direc-
tors Failed as Shareholder Watchdogs?” Working Paper, SSRN,
July 30, 2008.
Palmiter, Alan R. “Mutual Fund Boards: A Failed Experiment
in Regulatory Outsourcing.” Brooklyn Journal of Corporate, Finan-
cial and Commercial Law, 1 (2006), pp. 161–205.
Zitzewitz, Eric. “Who Cares About Shareholders? Arbitrage
Proofing Funds.” Journal of Law, Economics, and Organization,
Vol. 19, No. 2 (October 2003), pp. 245–280.
——. “How Widespread Was Late Trading in Mutual Funds?”
American Economic Review, Vol. 96, No. 2 (May 2006), pp. 284–289.
To order reprints of this article, please contact Dewey Palmieri at
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