Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds

As is becoming increasingly widely known, mutual funds often calculate their net asset values using stale prices, which causes their daily returns to be predictable. By trading on this predictability, investors can earn 35-70 percent per year in international funds and 10-25 percent in asset classes such as small-cap equity and high-yield and convertible bonds. These abnormal returns come at the expense of long-term share-holders, dilution of whom has grown in international funds from 56 basis points in 1998-9 to 114 basis points in 2001. Despite these losses and pressure from the SEC, the vast majority of funds are not market-updating their prices to eliminate NAV predictability and dilution, but are instead pursuing solutions that are only partly effective. The speed and ecacy of a funds actions to protect shareholders from dilution is negatively correlated with its expense ratios and the share of insiders on its board, suggesting that agency problems may be the root cause of the arbitrage problem.