What Mutual-Fund Scandal



What Mutual-Fund Scandal?

By HENRY G. MANNE

January 8, 2004

For months now, Eliot Spitzer has terrified the investing public with lurid charges of mutual-fund high jinks. Vast sums of money are alleged to have been lost by long-term investors because some funds allowed a favored few to engage in late trading (using new information to trade in funds at the "stale" price after the legal 4 p.m. closing time) or market timing (basically arbitraging stale-priced funds within fund families). But there is much more innocent behavior and more public welfare in this mutual-fund story than has appeared in the press, and vastly less damage than Mr. Spitzer would have us believe.

The economic justification for much of Mr. Spitzer's claims rests squarely on a recent, widely cited academic paper, "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," by Prof. Eric Zitzewitz of the Stanford Graduate School of Business. This paper purports to show that the various late-trading or market-timing schemes are costing long-term investors in American mutual funds about $4.9 billion a year. The problem is that the paper demonstrated no such thing.

After explicitly acknowledging that there was no direct way of measuring the dilution of long-term fund investors' interests, Mr. Zitzewitz estimated the maximum amount that arbitrageurs or short-term traders could theoretically make from such trading. He then simply assumed that the long-term investors had lost that much in dilution of their shares. But he took no account of individuals' and funds' responses to the behavior under investigation. Like static tax projections, which fail to account for behavioral responses to a proposed tax change itself, Mr. Zitzewitz's measure wrongly implies that long-term investors or fund mangers would sit passively by while returns in their funds were being deeply eroded. Not bloody likely.

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The U.S. mutual-fund industry is extremely competitive: 11,000 funds managed by 500 mutual-fund companies. Information about these funds abounds, both that required by law and that voluntarily published. Fund returns, reported daily, are scrutinized minutely by rating agencies and individual and pension portfolio managers, who can quickly and cheaply shift from one fund or management company to another. And even this is but a small part of the total market for investors' funds, which also includes direct stock purchases, savings accounts, insurance, real estate, even consumption. The demand for mutual-fund services is extremely elastic, approaching that for corn or wheat.

A highly competitive capital market will constantly tend to force things into equilibrium, with fund investors receiving a correct rate of return for the risk they assume. Timing practices may indeed occasion some immediate fund-dilution loss -- probably significant only if managers are slow to recognize the presence of timers or if necessary adjustment costs are high. But if the investors do not promptly receive the competitive market return, they will simply move their funds elsewhere until they do.

Nevertheless, we know that market timers and late traders have made profits. And, since their activities are not on their face either wealth-producing or wealth-enhancing, we want to know where those profits came from; and, if they came from the funds, whether there were any compensating benefits. But it is certainly not acceptable to assume, as Mr. Zitzewitz did, and as Mr. Spitzer zealously approved, that timers' revenues are actually being squeezed out of long-term investors.

Since the demand by investors for fund services is extremely elastic, any burden from timing costs would rest with fund managers or fund-management companies, according to their respective demand elasticities. Tax consequences apart, long-termers would suffer only a small and temporary loss, if any, since the cost of avoiding any diminution in return by shifting to another fund or to another investment with a higher return is relatively small and transient.

But the funds and their managers could shift all or a part of timing costs back to the timers even if investors are locked in by capital-gains taxes. One device for doing this was to charge a high front-end load for all trades. This would spread an occasional one-time cost over a long period for long-term investors but would be prohibitive for frequent traders. Thus long-term investors might reasonably accept a high front-end load as the price of keeping timers out. (So why is Mr. Spitzer complaining about these fees?) Fund companies could also refuse to do business with timers, a solution that several adopted. Others simply specify that only a small number of trades would be allowed in a given period.

Some fund managers undoubtedly realized that a high enough net return in fees from having more trades and larger fund assets could make up for any loss from dilution and added administrative costs imposed by timers. This might have been especially true either for smaller firms eager to boost the total amount of money under their management or for funds that in effect compensated long termers for anticipated dilution losses by charging them little or no load or redemption fee. In any event, many firms recognized, implicitly or explicitly, that the existence of timers and non-timers in one market provided an opportunity for differential pricing that could benefit everyone.

The airline industry provides an analogy. Business flyers, with high time costs, place a higher dollar value on air travel than do most leisure travelers. By charging everyone the same price, the airlines were losing some surplus they could command by charging a differentially higher price for business travelers. The single-price system meant higher total average fares, fewer flights and less leisure travel. The airlines found that they could discriminate between business and leisure travelers by charging different fares for different lengths of stay or for travel over particular days of the week. Business travelers now pay relatively more for their travel, but total social welfare is maximized by this use of differential pricing.

This is very much like the mutual-fund industry where some investors, the timers, could get a higher economic value from funds than others. The funds found a way to charge them a higher price, and everyone but the timers was made better off. The funds and their long-term investors shared in the "surplus" realized only by timers in a single-price system, and the timers were still allowed to do their thing, albeit at a higher price. Fees were set at varying higher levels for rapid traders, who were, of course, far more likely to be the timers. Long-term investors, the leisure flyers of the industry, paid a lower management or redemption fee, or received a higher rate of return for the same fee.

Anyone was free to use either system. This scheme, certainly no secret or concealed fraud, seems to have worked fairly well, judged by the enormous growth in mutual fund deposits while this was going on. However, in 1983 the SEC established what amounted to a 2% cap on regular redemption fees. For some funds, for which the price discrimination device had proved profitable, the cap amounted to a form of price control preventing them from recovering part of the timers' surplus. The incentive was now created for some sort of "black market" to replace the higher redemption fees the funds had previously used as an efficient price-discrimination device. Like all black markets, this one would have higher transactions costs than unregulated markets, but it would still move economic resources in a welfare-enhancing direction.

Various techniques have been used by funds, on the supply side, to accommodate the timers and secure their high-profit business. One was simply to ignore the legally mandated 4 p.m. closing time for transactions (clearly illegal); another was to ignore the funds' own restrictions on the number of trades that could be made in a period of time (perhaps a breach of contract, but hardly criminal in itself). The timers could pay more by "parking" large sums in related but unused funds or, perhaps in cases yet to be uncovered, by making illicit payments under the table.

If the industry had never been regulated, it is doubtful that we would be seeing any of this. Differential pricing and services would be commonplace, and it is even possible that a derivatives market relating to fund shares would have developed. Different firms would adopt different strategies depending on their size, comparative advantage and cost conditions, and the market would have settled on a correct equilibrium. There would be no scandal.

Mr. Spitzer will undoubtedly be surprised to learn that the timing practices he so roundly condemns actually helped investors, and the class-action lawyers will certainly not like learning that any real damages are orders of magnitude less than they hoped. But serious investors can rest secure in the knowledge that they are not fools to continue investing in mutual funds. The fools are the ones who thought they had uncovered a vast swindle when in fact all they had really done was demonstrate that beneficial market forces are always at work.

Mr. Manne, a resident of Naples, Fla., is dean emeritus of the George Mason University School of Law.

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