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The economics of the mutual fund trading scandal

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  • Patrick E. McCabe
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    Abstract

    I examine the economic incentives behind the mutual fund trading scandal, which made headlines in late 2003 with news that several asset management companies had arranged to allow abusive--and, in some cases, illegal--trades in their mutual funds. Most of the gains from these trades went to the traders who pursued market-timing and late-trading strategies. The costs were largely borne by buy-and-hold investors, and, eventually, by the management companies themselves. ; A puzzle emerges when one examines the scandal from the perspective of those management companies. In the short run, they collected additional fee revenue from arrangements allowing abusive trades. When those deals were revealed, investors redeemed shares en masse and revenues plummeted; management companies clearly made poor decisions, ex post. However, my analysis indicates that those arrangements were also uneconomic, ex ante, because--even if the management companies had expected never to be caught--estimated revenue from the deals fell well short of the present value of expected lost revenues due to poor performance in abused funds. ; Why some of the mutual fund industry's largest firms chose to collude with abusive traders remains something of a mystery. I explore several possible explanations, including owner-manager conflicts of interest within management companies (between their shareholders and the executives who benefitted from short-term asset growth), but none fully resolves the puzzle. Management companies' decisions to allow abuses that harmed themselves as well as mutual fund shareholders convey a broader lesson, that shareholders, customers, and fiduciary clients be cautious about relying too heavily on firms' own self-interest to govern their behavior.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2009-06.

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    Date of creation: 2009
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    Handle: RePEc:fip:fedgfe:2009-06

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    Keywords: Mutual funds ; Financial services industry ; Fraud;

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    References

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    1. Chevalier, J. & Ellison, G., 1996. "Risk Taking by Mutual Funds as a Response to Incentives," Working papers 96-3, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
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    9. Rahul Bhargava & Ann Bose & David A. Dubofsky, 1998. "Exploiting International Stock Market Correlations with Open-end International Mutual Funds," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 25(5&6), pages 765-773.
    10. Paula A. Tkac, 2004. "Mutual funds: temporary problem or permanent morass?," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 1-21.
    11. Susan E. K. Christoffersen, 2001. "Why Do Money Fund Managers Voluntarily Waive Their Fees?," Journal of Finance, American Finance Association, vol. 56(3), pages 1117-1140, 06.
    12. Edelen, Roger M., 1999. "Investor flows and the assessed performance of open-end mutual funds," Journal of Financial Economics, Elsevier, vol. 53(3), pages 439-466, September.
    13. Zitzewitz, Eric, 2002. "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," Research Papers 1749, Stanford University, Graduate School of Business.
    14. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    15. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, vol. 35(1), pages 45-70, April.
    16. John M. R. Chalmers, 2001. "On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option," Journal of Finance, American Finance Association, vol. 56(6), pages 2209-2236, December.
    17. Greene, Jason T. & Hodges, Charles W., 2002. "The dilution impact of daily fund flows on open-end mutual funds," Journal of Financial Economics, Elsevier, vol. 65(1), pages 131-158, July.
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