Abstract
This paper reviews the size and scope of the mutual fund arbitrage problem, the inadequacy of the most popular solutions adopted by the industry to date, and the surprisingly slow response of many funds to the issue. 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 and provides arbitrageurs in international funds the opportunity to earn abnormal returns of 40-70 percent per year at the expense of buy-and-hold shareholders. Smaller but still substantial arbitrage opportunities exist in other asset classes such as domestic small-cap equity and high-yield and convertible bond funds. The solutions most commonly proposed by the industry - short-term trading fees and monitoring of market timers - are sometimes effective in shifting arbitrage activity to other funds, but will not be sufficient once all funds have adopted them. Adopting fair-valuing pricing to eliminate NAV predictability is a preferrable solution. Most funds have reacted surprisingly slowly to this issue, exposing their shareholders to dilution as high as 2 percent per year. The speed and efficacy of reaction is negatively correlated with expense ratios and the share of insiders on the board, suggesting that fund governance may be important in determining whether funds take actions to protect their shareholders.
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