Three years ago, the business scandal spotlight moved to a new industry when mutual funds were accused of allowing favored customers to engage in late trading and market timing that hurt ordinary investors. Since then, fund companies and individuals have paid more than $4 billion in restitution and fines, and regulators have been searching for ways to prevent or discourage short-term fund trades.
But although the scandal has subsided, some questions about these strategies have gone unanswered. Is short-term trading encouraged by the use of out-of-date, or “stale,” stock prices in valuing fund shares? Will remedies such as redemption fees, mandatory holding periods and “fair-value pricing” work? And can they work without penalizing ordinary investors?
To find out, Wharton finance professors Marshall E. Blume and Donald B. Keim looked at stock and mutual fund data from 1993 through 2004. The result is their recent paper, Stale or Sticky Stock Prices? Non-Trading, Predictability, and Mutual Fund Returns.
“What our paper shows is that you need some device other than fair-value accounting to stop the potential for market timing,” Blume says, referring to proposals to change the way fund shares are priced at the end of each trading day. “Anything that works to deter market timing harms other individuals.”
The net asset value, or price, of a mutual fund share is calculated by the fund company after the 4 p.m. close of each trading day. The closing price of each stock in the fund is multiplied by the number of shares held. The result — the total value of the fund’s holdings — is divided by the number of fund shares owned by investors, determining the share price for that day. Investors who had placed orders to buy or sell the fund’s shares during the day have their orders filled at this price.
However, the stock prices used in this calculation are often slightly out of date. This is especially so with foreign-company stocks traded on exchanges in Europe, Asia and elsewhere. Those exchanges close many hours before the 4 p.m. New York time used in pricing fund shares. The fund price is therefore based on stock prices that do not reflect news that took place after the foreign exchanges closed — making the fund price “stale.”
In theory, investors can profit from staleness by, for example, purchasing shares likely to go up tomorrow when the foreign market reacts to news that broke late today.
Market timing — bets on short-term moves in fund prices — is legal so long as the fund lets all shareholders do it. The fund companies that got into trouble were permitting only favored investors to make the quick-turnaround trades this strategy requires. Short-term trading generates lots of expenses for the fund — expenses borne by all of its shareholders.
In late trading, which is generally illegal, a trader is allowed to buy or sell at that day’s price even if he places the order after 4 p.m., though a late order is supposed to be filled the next day — at the next day’s closing price. This gives the trader a valuable edge because key news, such as the quarterly earnings report, is often released after the market closes. For the favored investor, the privilege of late trading is like having a time machine that allows him to buy at the old price after hearing news that is sure to drive the price up the next day.
Late traders effectively bought shares at a discount — the previous day’s price — while the fund had to pay full price to buy the stocks needed to create the fund shares the late traders ordered. In effect, other fund shareholders made up the difference between the actual cost of those stocks to the fund and the price paid by the late traders.
Momentum and Predictability
While the benefits of trading with stale prices is easy to see with foreign stocks, where prices can be many hours out of date, Blume and Keim noticed that many of the funds involved in the scandals were trading U.S. stocks, where the staleness was likely to be less extreme.
“If you go look at the actual mutual fund cases, you find that many of them are domestic funds,” Blume said.
The study started by measuring the staleness in U.S. stock prices. Stocks were divided into 10 groups based on market capitalization, or the size of the companies that issued the shares. The professors found that 99.5% of the largest stocks traded within the last five minutes of the day, meaning their closing prices almost perfectly reflected the most up-to-date information. A fund owning such stocks and valued at the 4 p.m. prices would therefore not be stale.
As stocks got smaller, the percentage traded in the last five minutes fell — to 60.6% for those in the middle group and 13.3% for ones in the smallest-stock group, for example. Hence, staleness increased for stocks of smaller companies. On the other hand, large stocks represent most of the trading. Thus, 96% of all stocks were traded in the last five minutes, resulting in little staleness in fund values. This suggests some factor other than staleness was attracting short-term traders.
In their next step, Blume and Keim looked at the “predictability” of fund prices. “That means, if it goes up today, it goes up tomorrow,” Blume says.
Various studies had shown that short-term predictability exists and can be measured. But what causes it? Could it be staleness — the fund price reacting to news a day late in a predictable way?
Blume and Keim put together a series of portfolios ranging from large stocks to small ones. They eliminated the effect of staleness by including only stocks that had traded in the final five minutes of the day. They found that the portfolios still exhibited a high degree of predictability, indicating that some factor other than staleness was at work — though staleness did contribute to predictability of funds holding smaller stocks.
Predictability, they concluded, was largely caused by “stickiness” and “momentum” — traders’ tendency to cling to their views of individual stocks. If traders liked a stock on one day, and bid up its price, they were likely to do the same the next day.
The conclusion: There is not much staleness in mutual funds that own U.S. stocks. Hence, market timing and late trading were mainly momentum-based strategies rather than stale-pricing strategies.
Since stale pricing is not the problem, Blume and Keim say it makes little sense for regulators to try to stop short-term trading by targeting staleness in fund pricing, as some reformers have urged.
One proposal, for example, would adjust each stock’s price at the end of the day by a factor based on futures trading in the Standard & Poor’s 500 index. The fund’s share price would thus, in theory, reflect what each stock would have traded for had it traded at the very end of the day, even if it did not. Using such fair-value pricing systems to set prices for fund shares would not deter market timers and late traders, because funds would still have the price predictability that attracts those traders, Blume and Keim argued.
Some reformers have suggested that short-term trading would be discouraged if traders were allowed only a limited number of transactions per year. But this would not fix the problem either, Blume and Keim say, because people could still concentrate their trades on days that short-term gains could be expected.
Another proposed remedy: a redemption fee charged to investors when they sell fund shares — a fee larger than the profits generally offered by short-term trades. The best deterrence, Blume and Keim say, would require a fee charged no matter how long the investor had owned the shares, but this would penalize all investors. As an alternative, the fee could be lifted once an investor had owned the shares for a given number of months or years. Unfortunately, this penalizes investors who are not market timers but need to redeem before the period ends for some other, perfectly proper reason.
What’s the ideal solution? “There isn’t one,” Blume says, as any approach will penalize ordinary shareholders to some degree. Still, he adds, a temporary redemption fee seems the least onerous of the alternatives.
Indeed, investors may soon find more fund companies imposing them. A rule passed in 2005 by the Securities and Exchange Commission made redemption fees easier to levy — and ordered fund companies to address the issue by mid-October, 2006.