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The
Blind Spot in Mutual Fund Investing| Finance Research By Eric Zitzewitz |
STANFORD GRADUATE SCHOOL OF BUSINESS — Blame it on globalization: That stock markets around the world are both more volatile and more closely correlated in their up-and-down movements than ever before is clear. Especially since the onset of the Asian economic crisis in 1997, followed by the collapse of the Internet bubble in 2000 and then the aftershocks of Sept. 11, equity markets around the world have swung faster, further, and in closer tandem than ever. That this volatility presents greater risks to market players attempting to stay ahead of the curve is no surprise. What is shocking is the extent to which such volatility, combined with the standard industry practice of pricing mutual funds just once daily, has allowed arbitrageurs to profit handsomely. And those profits come at the expense of long-term investors, to the tune of $4 billion a year in dilution. Worse yet, this problem has been known for at least two decades, while little has been done about it.
That
estimated $4 billion dilution level is part of a new study by Eric Zitzewitz,
assistant professor of strategic management at the Stanford Graduate School
of Business. The problem lies with the fund industry practice that he
calls "stale" pricing. Mutual funds typically calculate their
net asset value (NAV) using the most recent market data as of 4 p.m. Eastern
Time. In any given trading day, long after the closing bell in Tokyo or
Frankfurt, foreign stock prices and the relative values of U.S. funds
holding them are in flux, but their NAVs have already been set. Thus,
the opportunity to profit by daily trading.
Zitzewitz realized the problem a few years ago, when he noticed that prices on some high-yield bond funds he owned were following very predictable patterns. "The funds would go up steadily for seven days and then drop for seven days, then rise for five days only to drop for five days," he says. "Market theory says that returns are supposed to be random, and yet clearly these returns were anything but."
His interest piqued, Zitzewitz delved into data for a broad sampling of mutual funds. He was able to document how daily returns are predictable enough in certain asset classes, most notably region-specific international funds, to permit a significant arbitrage opportunity. By taking advantage of time zones to trade daily in and out of certain international funds as foreign prices rise and fall in response to the U.S. market, but while those funds' NAVs are fixed, arbitrageurs could earn excess annualized returns of anywhere from 35 to 47 percent.
A stunning example of one-day arbitrage profiteering occurred on Oct. 28, 1997, in the midst of the Asian economic crisis, when Asian markets closed sharply down following a 9 percent drop in the S&P 500. However, after Asian markets closed, Wall Street rallied by 10 percent from its morning low. Most U.S.-based Asian funds had set their NAVs according to Asian closing prices—allowing arbitrageurs to earn one-day returns of 8 to 10 percent.
Zitzewitz adds that there are smaller but still significant returns to be had in domestic small-cap equity, and convertible and high-yield bond funds, which tend to trade less often than large-cap stock funds. Their relative illiquidity means their prices also can be stale relative to the NAV, similar to the effect of a time difference.
"The fact is, no one arbitrages in small caps, because if they know about the [illiquidity] problem there, they know about the international funds. And you can make more money in the international," Zitzewitz notes. "But 10 years from now, when they fix the problem in international funds, there's going to be a problem in small-cap funds too." Meanwhile, the cost to long-term shareholders, whose investments are diluted by these market-timers' inflows and outflows, is as much as 2 percent annually, adding up to a whopping $4 billion, says Zitzewitz.
Zitzewitz is not the first to notice this problem. The sad fact is the issue of stale pricing has been known in the industry for some 20 years. Only a few funds have taken any steps to correct it, and those measures are only partially successful. The most common solution is the imposition of short-term trading fees ranging from 0.25 to 3.5 percent. The net result of such fees, Zitzewitz has found, is that they lessen, but do not eliminate, large profits. In a fund with a 1 percent fee—typical for a European fund—Zitzewitz says that traders still would net 25 percent excess returns, versus 40 percent without the fees. In short, hardly a disincentive.
From the long-term investors' perspective, their dilution in funds with short-term fees in place is 50 percent lower than in funds without them, but still not zero. "The net result is [funds that impose] these fees can redirect arbitrage to other fund families, but once they all adopt them, it won't stop the problem," Zitzewitz points out. Short-term fees also can be difficult to apply in 401(k) plans, and impossible in certain variable annuity products where the annuity contract was signed prior to imposing the fees and rules prohibit modifying the existing contract. Other funds use American Depository Receipt (ADR) prices to set foreign security prices in determining fund NAVs. Zitzewitz says that most ADRs are fairly illiquid, so this is a partial solution at best.
The only satisfactory solution, Zitzewitz argues, is to do fair-value pricing—updating prices to take into account market-moving events. Some funds do a partial, top-down variant of this, which is more of an ad hoc adjustment to the overall portfolio value. A better approach is to fair-value each individual security; fair-value NAVs will thus fully reflect recent portfolio changes. Vanguard's Pacific Index fund is one of the few that seems to be correctly adjusting its NAV, in conjunction with aggressive monitoring of short-term trading, Zitzewitz says.
The Securities and Exchange Commission also has taken an interest in the problem. The SEC issued a letter on the subject on April 30 last year; however, it has stopped short of requiring funds to fair-value, or even to disclose the dilution to long-term investors. Until the day fair-value pricing becomes the industry standard, the best way individual investors can protect themselves is to seek out funds with low expense ratios and a healthy proportion of outsiders on the board of directors—both signs of good fund management, according to Zitzewitz. He has found that funds with one or both of these attributes are most likely to have partial remedies like trading fees in place. And if investors are still determined to hold international funds for diversification's sake, Zitzewitz recommends sticking to broad global funds rather than region-specific ones, not least because a global fund will be half U.S. stocks and thus less attractive to arbitrageurs.
In another 20 years, the industry may get around to fixing the problem. In the meantime, long-term buyers beware.
by Andrea Hamilton
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FOR MORE INFORMATION: To order a paper in the GSB Research Paper Series
(numbered papers only), email research_papers |
Monitoring Trades for the Good of the Fund, New York Times, April 9, 2000
Frequent Trading Worries Fund Firms, Wall Street Journal, Sept. 22, 2000
Your International Fund May Have the 'Arbs Welcome' Sign Out, TheStreet.Com, June 10, 2000
International Funds Still Sitting Ducks for Arbs, TheStreet.Com, July 1, 2000
SEC Finally Moves to Stop Arbs Who Prey on Foreign Funds, TheStreet.Com, Feb. 6, 2001
SEC to Mutual Funds: Take Down 'Arbitrage Welcome' Signs, TheStreet.Com, May 2, 2001
Legal Challenge to Mutual Fund Trading, Business Week, September 4, 2003 [Details]
What To Do if You Own Nations, San Francisco Chronicle, September 11, 2003 [Details]
Research
Who Cares About Shareholders? Arbitrage Proofing Mutual Funds, Eric Zitzewitz, GSB Research Paper #1749, March 2002
J. Darrell Duffie, Using Hedge Funds as Alternative Investment Vehicles
J. Darrell Duffie, Tax Shield May Make Convertible Bonds Attractive
J. Darrell Duffie, Short Selling May Affect Stock and Bond Prices
More Research Papers
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