Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds

Abstract

As is becoming increasingly widely known, mutual funds often calculate their net asset values (NAVs) using stale prices, which causes their daily returns to be predictable. By trading on this predictability, investors can earn 35–70% per year in international funds and 10–25% in asset classes such as small-cap equity and high-yield and convertible bonds. These abnormal returns come at the expense of long-term shareholders, dilution of whom has grown in international funds from 56 basis points in 1998–99 to 114 basis points in 2001. Despite these losses and pressure from the Securities and Exchange Commission (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 efficacy of a fund's 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.