Protecting Fund Shareholders from Costly Share Trading

In the wake of revelations that many mutual funds have not protected fund shareholders from abuse by late traders and market timers, the emphasis of most regulators and pundits has been on strengthening compliance. But although stopping abuses is important, most of the abuses cited are possible only because the standard mutual fund pricing and trading processes are inherently flawed. Most fund share trades that arrive late in the day are costly to existing fund shareholders whether the trades were initiated by short-term traders or by other investors. Investors and regulators need to understand how costly the current trading and pricing processes are and how to fix the problems. In the wake of revelations that many mutual funds have not protected fund shareholders from abuse by late traders and market timers, the emphasis of most regulators and pundits has been on strengthening compliance with existing trading rules and with policies stated in fund prospectuses. But although stopping abuses is important, most of the abuses cited are possible only because the industry standard for mutual fund pricing and trading is inherently flawed. Most fund share trades that arrive late in the day are costly to existing fund shareholders whether they were initiated by short-term traders (e.g., market timers) or by ordinary investors.Orders the fund does not receive by early afternoon cost fund shareholders about $40 billion, or 1 percent of equity fund assets, each year. A study to measure the cost of providing liquidity to entering and leaving fund shareholders found that the trading costs attributable to offering liquidity created an average net reduction in annual investor return of about 1.43 percent. With the latest available figures showing assets in U.S. stock and hybrid funds at about $4 trillion, applying a cost of providing liquidity of only 1 percent puts the estimate easily at $40 billion. A few funds have succeeded in eliminating the impact of these trading costs by cutting off buy, sell, and exchange orders early in the afternoon. They trade for the fund portfolio before the market close so that the cost of flow trading is reflected in the net asset value (NAV) calculation that prices the shares for entering and leaving shareholders. If all funds had such policies, fund investors’ returns might improve by more than $40 billion a year. I suggest a possible solution to this free-liquidity problem based on three policy changes: For domestic equity or balanced funds, any open mutual fund would accept purchase orders and all redeemable funds would accept redemption orders delivered to the advisor until 2:30 p.m. on any normal business day for pricing at that day’s NAV. No order cancellations would be permitted after 2:30 p.m. , and the fund could trade to adjust its portfolio for these investor orders before the market close. After 2:30 p.m. , market makers unaffiliated with the fund advisor would be able to provide liquidity to investors who wanted to enter orders for execution at share prices based on that day’s NAVs. For funds holding more than 3 percent of their assets in stocks traded in one or more primary markets outside the United States, orders would be accepted until 4:00 p.m. on any U.S. business day for pricing at the NAV next determined for the fund after a full trading day in the primary markets for stocks accounting for 97 percent of the fund’s equity portfolio. This proposal would eliminate the need for redemption fees. Advocates with diverse perspectiveshave endorsed redemption fees to discourage short-term traders in fund shares. If a trader avoids the redemption fee by staying past the redemption fee cutoff date, however, the cost of the fund’s portfolio trading to accommodate the trade becomes a permanent cost to other shareholders—without any offsetting benefit from a redemption fee. With a 2:30 p.m. cutoff, the portfolio manager has the opportunity to invest money coming in or liquidate positions to cover redemptions at contemporary prices. Moreover, the fund’s trades between 3:00 p.m. and 4:00 p.m. will affect and help update the prices used in the NAV calculation. To the extent that a 2:30 p.m. order cutoff encourages more trading in domestic securities in the last hour before fund pricing, the prices used in the NAV calculation will be more current than they are now. And redemption fees and fair value pricing will be less necessary.