How Widespread is Late Trading in Mutual Funds? Eric Zitzewitz * Stanford Graduate School of Business

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1 How Widespread is Lae Trading in Muual Funds? Eric Zizewiz * Sanford Graduae School of Business Firs draf: Sepember 2003 This draf: November 2004 Absrac. This paper uses daily fund flow daa o examine he exen of lae rading in he U.S. muual fund indusry. Trading decisions ha are required by law o have been made before 4 PM Easern Time are correlaed wih marke movemens from 4 o 9 PM ha evening. The cross-secional variaion in his correlaion is consisen wih lae rading being is primary cause and inconsisen wih alernaive explanaions. For example, apparen lae rading ceases in Sepember 2003 afer he announcemen of he invesigaion ino muual fund rading pracices, i is hree imes greaer in fund families ha have been cied by regulaors for allowing lae rading, and i is greaer in funds and asse classes ha are also receiving heavy sale price arbirage flows. In my sample, which includes 75 percen of non-specialized equiy muual funds and 48 percen of asses, lae rading led o average annual shareholder diluion from 1998 o 2003 of 3.8 and 0.9 basis poins in inernaional and U.S. equiy funds, respecively. If hese diluion raes prevailed indusry wide, hey would imply shareholder losses of abou $400 million per year. Furhermore, here is saisically significan evidence of lae rading in he funds of 39 of 66 fund families. * 518 Memorial Way, Sanford, CA Tel: Fax: ericz@sanford.edu. The auhor would like o hank David Brown, Charles Calomiris, Sean Collins, Frank Edwards, Larry Harris, John Rea, Brian Reid, Jon Reuer and seminar paricipans a he American Enerprise Insiue, Columbia, NYU, he SEC, UC-Boulder, and several indusry groups for helpful suggesions and commens. Thanks also o Andrew Clark of Lipper and Charles Biderman of TrimTabs for sharing heir daily fund flow daa and for helpful conversaions abou he daa.

2 How Widespread is Lae Trading in Muual Funds? Inroducion One of he major componens of he so-called Muual Fund Scandals of 2003 is he allegaion ha cerain invesors were allowed o engage in he lae rading of muual fund shares. Under he forward pricing rule, rades in U.S.-based open-ended muual funds are o be priced a he nex ne asse value (NAV) calculaed afer an order is received. 1 The vas majoriy of U.S.-based muual funds calculae NAVs once per day a 4 PM Easern Time, and so, for hese funds, orders received before 4 PM should be priced a he NAV calculaed on he day of he rade while rades received afer 4 PM should insead be priced a he nex-day ne asse value. 2 Lae rading occurs when invesors place rades afer 4 PM bu sill receive he 4 PM price. These lae raders can use he informaion revealed afer 4 PM o guide heir rades: buying funds when heir curren value is greaer han heir 4 PM value and selling he funds when he reverse is rue. Doing so allows hem o earn expeced abnormal reurns a he expense of he fund s long-erm shareholders. This paper presens a mehodology for using daily muual fund flow daa o es for wheher lae rading has occurred in a paricular fund. Using his mehodology and daily flow daa from approximaely 75 percen of U.S.-based equiy muual funds (represening 48 percen of asses), i esimaes ha average losses o long-erm 1 See rule 22c-1 enaced in 1968 under he Invesmen Company Ac of Invesors in open-ended muual funds buy and sell shares from he fund iself, conribuing or receiving he fund s ne asse value per share on he day of he rade. 2 One of he legal defenses ha will apparenly be used by some of hose accused of lae rading is o claim ha he ime of NAV calculaion refers o he ime ha he calculaion is acually performed, usually minues afer 4 PM, as opposed o he ime he NAV is calculaed as of. Regulaors do no agree ha his is a reasonable inerpreaion of he law, bu i remains o be seen if his defense will prevail in cour. See, e.g., Sewar (2004) and Wells and Wighon (2004). 2

3 shareholders from lae rading were 3.8 and 0.9 basis poins in inernaional and domesic equiy funds from , respecively. If similar diluion raes prevailed ouside he sample, annual losses o lae rading would be approximaely $400 million per year. Fund family-level ess reveal saisically significan evidence of lae rading in 39 ou of 66 fund families. Tha lae rading was his widespread may no longer seem surprising given he ongoing corroboraion of his resul by evidence gahered by regulaors, bu when he firs draf of his sudy was circulaed in early Sepember 2003, i surprised some indusry paricipans o he poin of disbelief. 3 The basic approach of his paper is o es wheher rades ha are supposed o have been placed before 4 PM are correlaed wih marke movemens afer 4 PM ha make he rade urn ou o have been advanageous. In my sample, his correlaion exiss wih marke movemens beween 4 and 9 PM, bu no wih pos-9 PM movemens. Clearly, if such a correlaion exiss, one of he leading candidae explanaions is ha some of he rading decisions in quesion were made as lae as 9 PM. Alernaive explanaions are considered, bu none fi he facs well. As addiional pieces of evidence ha hese correlaions are indeed indicaive of lae rading, I noe: 1) ha my esimae of lae rading is roughly hree imes higher for muual fund companies ha have been cied for allowing lae rading in enforcemen acions as of April 2004 and 2) ha esimaed lae rading fell fairly sharply in mid-o-lae 2003, when invesigaions by federal and sae regulaors began. 4 3 See, for example, indusry paricipans quoed in Buron (2003), Hechinger (2003) and Nelson (2003). 4 A cavea: my undersanding is ha mehods similar o hose oulined in his paper have been used by regulaors o es for or corroborae evidence of lae rading, so he fac ha named funds have higher measured lae rading may be parly relaed o his similariy of measuremen echniques. 3

4 Why should economiss, as opposed o regulaors and prosecuors, care abou lae rading or any of he oher issues raised in he recen invesigaions? One reason is ha muual funds have become a or even he primary invesing and reiremen savings vehicle in he U.S., especially for middle and upper-middle class invesors. While he drain from hese savings due o lae rading was fairly modes in percenage erms, he discovery of lae rading has helped promp a reassessmen of agency problems in and hidden coss of muual fund invesing. This sudy hus conribues o a lieraure ha includes work documening he exen of sale price arbirage (Greene and Hodges, 2002; Zizewiz, 2003), sof dollars and 12b1 fees (Siggelkow, 2003), favoriism wihin fund families (Gaspar, Massa, and Maos, 2003), he high level of expenses and commissions (Horascu and Svensson, 2004), and risk aking in response o incenives (Chevalier and Ellison, 1997). I also can be viewed as adding o a broader se of sudies ha use saisical echniques o deec illegal aciviy. The remaining secions in his paper provide background on lae rading, describe he daa and mehodology, presen he resuls, and examine alernaive explanaions. A discussion follows. I. Background Muual funds were widely abused by insiders in he 1920s. 5 For example, during cerain hours of he day, insiders could simulaneously rade a oday and yeserday s prices, exracing money from he fund a he expense of long-erm shareholders. The Invesmen Company Ac of 1940 aimed o resore invesor confidence by prevening 5 See Baumol, e. al. (1990) and Ciccoello, Edelen, Greene, and Hodges (2002) for deails. 4

5 hese and relaed abuses, and conains numerous provisions designed o ensure ha NAVs used for ransacions accuraely reflec he curren value of he fund. Prior o 1968, however, mos muual funds praciced backward pricing, pricing rades using he mos recen prior NAV. This creaed an analogous opporuniy for invesors, paricularly hose who were able o avoid sales loads, o dilue long-erm shareholders by buying shares in a fund on days in which he marke value of is asses had risen. On such days, he NAV used o price he ransacion was less han he curren value of he asses a he ime he rade was placed. 6 The forward pricing rule was adoped o proec average shareholders from his diluion. The rule is exremely well known hroughou he indusry, since i deermines he daing and hus he pricing of muual fund rades. Sae and federal regulaors have alleged ha cerain invesors were allowed o place rades afer 4 PM, in some cases as lae as 9 PM, ha received he 4 PM price. This lowered he reurns of he funds involved, bu favored invesors ofen paid for he privilege, eiher direcly or via so-called sicky asse deals, in which hey placed addiional monies in high-expense raio invesmens. The degree o which funds were aware of illegal lae rading in heir funds varies. In some cases, fund managemen companies had direc knowledge of he lae rading. In ohers, he lae rading was execued hrough inermediaries, such as brokerage firms. Muual funds have radiionally allowed inermediaries exra ime afer 4 PM o oal he day s orders before reporing hem o he fund; some inermediaries allegedly used ha 6 The difference beween a fund s curren value and is las NAV was also used by brokers as an inducemen o encourage cliens o buy a fund. A he ime he forward pricing rule was proposed, an official of a large Easern no-load muual fund bemoaned he loss of a good sales ool. (Wall Sree Journal, 6/26/1968, 2). 5

6 exra ime o add or delee rades afer 4 PM. In hese cases, he fund managemen company was usually aware of high-frequency rading in heir funds and in some cases had obained compensaion for allowing he rading, bu was no necessarily aware ha he rading decisions were being made afer 4 PM. Lae rading is relaed o a pracice commonly called marke iming. A marke imer rades muual funds a high frequency bu makes rading decisions before 4 PM. Ofen, he moivaion for marke iming is o exploi he fac ha in many asse classes, he mos recen price as of 4 PM is sale, i.e. does no fully reflec recen marke movemens. 7 Examples include inernaional equiies (due o he earlier closure of foreign markes) and less-liquid asses such as small-cap equiies and high-yield and municipal bonds. As is he case wih lae rading, he marke imer buys (sells) funds following posiive (negaive) marke movemens, when he curren fund value is above (below) he NAV, diluing long-erm shareholders in he process. Unlike lae rading, marke iming has been documened in he academic lieraure and discussed in he popular press. 8 Marke iming is legal, whereas lae rading is no. Bu he SEC has been encouraging funds o resric marke iming opporuniies hrough a combinaion of fairvalue pricing (i.e., updaing sale prices o reflec recen marke movemens) and oher deerrens such as monioring and shor-erm rading fees. A leas unil mid-2003, mos fund companies showed a srong preference for addressing he problem solely hrough 7 Marke iming is a misnomer, since a marke imer in an inernaional fund is usually no invesing o ime he marke, bu o exploi he sale pricing of muual fund shares. Bu since marke iming is he erm ha is widely used by indusry, I will use i as well in his paper. 8 Academic papers on he subjec include Bhargava, Bose, and Dubofsky (1998), Chalmers, Edelen, and Kadlec (2001), Goezmann, Ivkovic, and Rouwenhors (2001), Greene and Hodges (2002), Boudoukh, Richardson, Subrahmanyam, and Whielaw (2002), and Zizewiz (2003). Press coverage from before Sepember 2003 includes Hulber (2000), Lucchei (2000), Bullard (2000), Sone (2002), and Carnahan (2003). 6

7 fees and monioring, despie he shorcomings of hese soluions. The mos noable shorcoming is ha whereas proper fair-value pricing removes diluion opporuniies from all invesors equally, i is difficul o ensure ha fees and monioring are applied o all invesors. I remarked on his puzzling preference for fees and monioring in Zizewiz (2003), and posulaed ha one possible explanaion was ha fund managers waned o preserve he righ o selecively allow diluion opporuniies o specific invesors. The curren invesigaions have revealed muliple insances in which fund managemen companies exemped specific invesors from fees and monioring in exchange for compensaion. Lae rading is ofen praciced in combinaion wih marke iming. Boh pracices are based on he underlying principle of rading using informaion no ye refleced in fund NAVs, boh involve he frequen buying and selling of funds, and boh are easier o implemen in large scale wih he compliciy of he fund manager. In several cases, arbirageurs were willing o pay muual fund companies for he righ o frequenly rade funds in asse classes in which he prices use o calculae NAVs are no sale as of 4 pm (e.g., large-cap equiy). Lae rading provides an explanaion for why hey migh have been willing o do so. II. Daa and Mehodology The basic approach of he paper is o deermine he exen of lae rading by measuring he correlaion beween daily muual fund flows and pos-4 PM marke movemens. Pos-4 PM movemens in liquid, efficien markes should be difficul o anicipae as of 4 7

8 PM, so if rading decisions are correlaed wih hese marke movemens, i may be evidence ha he rading decisions were made afer 4 PM. A simple example of a regression esing for lae rading would be he following: flow asses 1 = β + β SP + β SP + β SP + ε. (1) 0 1 3:00 11: :30 16: :15 21:00 The dependen variable is ne inflows o he fund, normalized by prior-day asses, where inflows are defined as he difference beween he asses of he fund(s) in quesion and he prior-day asses adjused for curren-day fund reurns. The independen variables are changes in he Chicago Mercanile Exchange near-monh S&P 500 fuures price. The firs wo erms conrol for marke iming using pre-4 PM informaion; he hird erm capures lae rading using pos-4 PM informaion. Conrolling for pre-4 PM marke movemens serves wo purposes: 1) i conrols for any correlaion beween pre and pos- 4 PM marke movemens which, given he liquidiy of he S&P 500 fuure, is minor, and 2) by reducing he variance of he error erm, i improves he efficiency of esimaion. 9 A saring ime of 4:15 is used for he hird erm o preven any saleness in he 4 PM S&P fuures price from improperly leading o an inference of lae rading. The S&P fuure is exremely liquid, wih bid-ask spreads ha are 1-2 basis poins a 4 PM, so any saleness should be minor. Nine PM is aken as he sopping ime since ha was he laes lae rading ime menioned in he complain agains Canary Capial Parners, LLC One migh include oher deerminans of flows ha are known as of 4 PM on he righ-hand-side as conrols; examples include disribuions and fixed effecs for seasonals (e.g., day of week, day of monh, monh). Doing so does no affec he resuls, as one would expec given ha heir effec on flows is smaller and ha hey are essenially uncorrelaed wih 4:15 o 9 PM marke movemens. 10 Sae of New York v. Canary Capial Parners, LLC (2003), Complain, p. 7. 8

9 Diluion of long-erm shareholders due o lae rading can be calculaed in wo ways ha are concepually differen, bu urn ou o be quaniaively equivalen in expecaion. The firs approach is o measure he reducion in fund asses from he apparen lae rades being priced a oday s raher han omorrow s NAV: E( flow I ) E( flow I dil 4 9PM 4PM 4PM 4PM = ( NAV+ 1 NAV ), (2) PM NAV ) where I 9PM is marke informaion available as of 9 PM. The second erm capures he presumed lae rades, measured as he change in he expecaion of flow due o pos-4 PM marke movemens. The second approach is o measure he reducion in fund asses relaive o wha hey would have been had rades placed by 9 PM been priced a a 9 PM NAV: dil = ( NAV 9PM NAV NAV 4PM 9PM E( flow ) = E( NAV I 4PM I PM ) E( flow 4PM NAV 9PM ) I 4PM ). (3) The difference beween (2) and (3) is he produc of unanicipaed NAV reurns and anicipaed flows (as of 9 PM); in expecaion, his produc mus be zero. 11 Equaion (3) can be viewed as a less noisy version of (2), since i eliminaes he componen of lae rading diluion relaed o pos-9pm marke movemens. Assuming ha rading decisions used only pre-9 PM marke informaion, hen his pos-9 PM componen migh be regarded as aribuable o luck raher han o he improper rading. 11 If he expecaions are esimaed in-sample using he same linear regression model for flows and reurns, hen (2) and (3) will be idenical, even in a finie sample. 9

10 The daily fund flow daa come from TrimTabs and Lipper, which collec daily asses, reurns, and disribuions from subses of U.S.-based open-ended muual funds. TrimTabs daa is available from February 1998 o December 2003; Lipper daa from March 2000 o December Since pos-4 PM marke indicaors are more readily available for equiy han for fixed income, I resric he sudy o U.S. and inernaional equiy funds and include only hose secor funds whose reurns are well prediced by general equiy indices (communicaion and echnology funds). Of he funds in he June 2001 Morningsar universe for hese caegories ha have ickers, 15 percen (28 percen of asses) appear in TrimTabs a some poin during he sample period, 71 percen (43 percen of asses) appear in Lipper, and 75 percen (48 percen of asses) appear in he combined sample. For funds appearing in boh sources for a given ime period, TrimTabs daa is used. 12 A small number of observaions from Lipper are eliminaed as ouliers. 13 An issue wih boh he TrimTabs and Lipper daa is ha inflows are repored wih a one-day lag for almos all funds (see Zizewiz, 2003, Secion 4 and Greene and Hodges, 2002, for a discussion of his issue). 14 I correc for his lag by calculaing flows assuming each day s asse figures are pre-flow raher han pos-flow, bu perform checks below o ensure ha his correcion is appropriae. For simpliciy, I use changes in he price of he near-monh S&P 500 fuure from he CME/Globex Time and Sales daa as a single indicaor of recen marke movemens. 12 Where TrimTabs and Lipper overlap, daily flow-o-asse raios are highly bu no perfecly correlaed (r = 0.93). No measures of flows are consruced by mixing daa from he wo sources. 13 Specifically, observaions in which he log of shares ousanding changes by more han 3 (i.e., he number of shares grows or shrinks by a facor of more han roughly 10 in a day) or wih log reurns greaer han 30 percen in absolue value are eliminaed as ouliers. This eliminaes abou 24,000 ou of 3.6 million fund-day combinaions; mosly due o he firs resricion. 14 An excepion o his are funds ha caer o high-frequency raders (e.g., Rydex, Profunds, Poomac), which do no repor wih a lag o TrimTabs (bu do repor wih a lag o Lipper). I drop hese funds from he sample. 10

11 The S&P fuure rades from 4:45 PM hrough o he following rading day every day excep Friday (and oher days preceding a marke closure). I experimened wih alernaive pos-4 PM indicaors (he Nasdaq 100 fuure for echnology funds; he Singapore Nikkei fuure opening price for Japan funds); hese indicaors were slighly beer predicors of nex-day reurns bu were no saisically significanly beer predicors of inflows. A he risk of undersaing lae rading in hese asse classes, I used he S&P 500 as a single indicaor for all asse classes. III. Resuls Table I presens esimaes of equaion (1) for inernaional and U.S. equiy funds, and for subcaegories hereof. Resuls are repored for boh equal-weighed and asse-weighed average inflows. The resuls sugges clear evidence of a correlaion beween pos-4 PM marke movemens and muual fund inflows, consisen wih lae rading. The correlaions sugges ha lae rading is mos prevalen in echnology, inernaional and small-cap equiy funds, suggesing ha lae raders focus on asse classes wih more volailiy and in which 4 PM NAVs are sale. Table II repeas he analysis wih a finer decomposiion of ime periods on he righ-hand side. The relaionship beween curren-day flows and marke movemens is saisically significan in every ime period unil 6 PM. The sum of he coefficiens from 6 PM o 9 PM is significan for inernaional equiy and all funds, alhough coefficiens for individual hourly figures are mosly no. Afer 9 PM, esimaed coefficiens are close o zero (and fairly precisely esimaed). The absence of a correlaion beween oday s inflows and pos-9 PM marke movemens suggess ha he correlaion wih 4 o 9 PM 11

12 marke movemens is no due o an inappropriae correcion for iming lags in he Lipper and TrimTabs daa. Comparing he pre and pos-4pm coefficiens for inernaional funds yields one measure of how widespread lae rading is. Suppose ha arbirageurs in inernaional funds rade eiher only on pre-4 PM marke movemens or on marke movemens hrough o 6 PM -- hey eiher do sale price arbirage only or combine i wih lae rading, bu never pracice lae rading as a sand-alone sraegy. Assume also ha heir invesmen rule is linear in expeced nex-day fund reurns. In his case, he (dollar-weighed) share of sale price arbirageurs who also lae rade is given by: β β pos 4PM flow pre 4PM flow β β pos 4PM reurn pre 4PM reurn. (5) This raio is roughly 30% using 11:30 AM o 4 PM and 5 o 6 PM as he wo periods, suggesing ha abou 30% of sale price arbirageur dollars were also raded unil 5 o 6 PM. The poin esimae for he 8 o 9 PM period is less precisely esimaed, bu is magniude also suggess ha abou 30% of arbirageur dollars were raded unil his ime. This is perhaps surprising given he modes conribuion of lae rading o he profiabiliy of arbirage rading inernaional funds. Table III presens esimaes of he abnormal reurns earned by a sale price arbirageur, a lae rader, and a rader employing boh sraegies ogeher. For domesic equiy funds, prices are no very sale as of 4 PM, and so lae rading conribues he bulk of he abnormal reurns. For inernaional funds he conribuion of lae rading is modes, however. 12

13 I is herefore a puzzle why so many inernaional fund arbirageurs engaged in illegal aciviy o raise heir reurns by such a modes amoun. One possibiliy is ha lae rading was only available o arbirageurs who were so large ha hey were compelled o rade in muliple asse classes, including asse classes like large-cap equiy ha were only profiable o rade using pos-4 PM informaion. Given ha hey were already lae rading domesic funds, even a small amoun of incremenal profi made lae rading inernaional funds aracive. Unforunaely, wih only fund-level daa, I canno es his hypohesis. Tables IV and V repor esimaes of he losses due o lae rading. These are calculaed using equaion (3) above, where NAV 9 PM and E(flow I 9PM ) are calculaed using he linear model in Table 2 (excluding he pos-9 PM righ-hand-side variables). Esimaing diluion using (2) yields quaniaively similar, bu less precise, esimaes. Lae rading losses are larges in echnology and inernaional equiy funds. Losses are large in 1998 and 1999, in 2001, and again in he firs eigh monhs of Unsurprisingly, esimaed lae rading drops afer Sepember 2003, when he invesigaion by sae and federal regulaors began. Equaions (2) and (3) can also be consruced using a non-linear model o esimae expeced flows and NAV reurns. Figure 1 plos kernel regressions of inflows on pos- 4PM marke movemens for inernaional, domesic, and echnology funds. The relaionship appears o be slighly convex, wih large posiive marke movemens being accompanied by greaer inflows; his is wha one would expec if some arbirageurs followed an asymmeric rading sraegy of owning he fund only on days wih large 15 The apparen decline from 1999 o 2000 is no relaed o he addiion of he Lipper funds o he sample; a similar decline is observed if he sample is resriced o he TrimTabs daa. 13

14 posiive expeced reurns. Tess for hese relaionships using a quadraic or a spline funcional form allowing for a slope change a zero do no rejec he linear model a sandard saisical confidence levels, however. One can also es he appropriaeness of he linear expecaional model by esing wheher NAV 4PM +1 NAV 9PM is correlaed wih flow +1 E(flow +1 I 9PM ). If oday s unexpeced flows are correlaed wih pos-9pm unexpeced reurns, i may indicae ha he expecaional model used by he economerician is less sophisicaed han he model used by arbirageurs. Tess for his correlaion do no rejec a he 5 percen significance level for any of he seven asse classes lised in Table I. Anoher way in which o examine how widespread lae rading was is o repea he analysis in Table I for individual fund families. My agreemens wih TrimTabs and Lipper preven me from reporing resuls for individual fund companies, bu a sufficien number of fund families have been named in SEC and sae invesigaions as of April 2004 ha I can repor resuls for hese families as a group. 16 If I replicae he asseweighed resuls Table I for named and unnamed fund families, I find ha coefficiens are neiher saisically nor economically significanly differen for eiher inernaional or U.S. equiy funds. If I limi he named firms o firms ha have been specifically cied for allowing lae rading, however, I find ha he coefficien for named firms is approximaely hree imes higher han for unnamed firms. This facor of 3 difference exiss for boh inernaional and U.S. equiy funds and is significan a he 1 percen level. Given ha hese firms represen abou 11 percen of asses in my sample, his implies ha 16 According o he Scandal Scorecard on WSJ.com, he following firms have been accused of allowing improper rading as of April 2004: Alliance, Alger, Amvescap, Bank of America, Bank One, Deusche, Federaed, Flee, Franklin-Templeon, Fremon, Janus, MFS, PEA/Pimco, Pilgrim, Punam, RS, Srong. Of hese, Alger, Alliance, Bank of America, Federaed, and MFS have been specifically cied for allowing lae rading. No all of hese firms are necessarily included in my combined sample. 14

15 abou 30 percen of he lae rading in my sample was conduced in fund families ha have already been cied for i. If I replicae Table I for individual fund families, I find saisically significan evidence (a a one-ailed, 95 percen confidence level) of lae rading in he inernaional funds of 40 ou of 71 fund companies in he combined sample. 17 In domesic equiy funds here is evidence of lae rading for 13 ou of 77 families. Among families wih sufficien daa available from boh asse classes, for 39 of 66 he join hypohesis of no lae rading in eiher asse class can be rejeced; 11 of hese families es posiive for lae rading in boh classes. This does no necessarily imply ha all 40 fund families were colluding wih lae raders. Firs, given a 95 percen confidence level, one would expec a false posiive rae of 5 percen. In addiion, sources such as he NYAG s complain agains Canary Capial Parners alleged ha lae raders ofen placed rades hrough inermediaries such as Bank of America or Securiy Trus Company; in hese cases funds may have been aware of he frequen rading, bu no of he fac ha rading decisions were being made afer 4 PM. The SEC repored in November 2003 ha jus over 10 percen of 88 large fund families admied o knowledge of lae rading in heir funds (Culer, 2003, 16). These survey resuls are self-repored, and may hus be downwardly biased, bu combined wih my resuls hey sugges ha some funds were aware of he lae rading, and some were no. 17 In oher words, he coefficien on he 4:15 o 9 PM marke movemens is posiive and significan for 40 ou of 71 fund families. The coefficien is negaive and significan for 2 of 71 and 4 of 77 families for inernaional and domesic equiy funds, respecively. Regressions for fund families are run by consrucing a ime series of oal inflows-o-oal asses raios for a family s funds in a given asse class. Fund families wih fewer han 5,000 observaions (fund*day combinaions) were excluded from his analysis. 15

16 IV. Alernaive Explanaions Wha, oher han lae rading, could produce a correlaion beween supposedly pre-4 PM muual fund orders and pos-4 PM marke movemens? As menioned above, one possibiliy is ha some funds in he TrimTabs and Lipper samples repor daily asse daa pos-flow raher han pre-flow, and inappropriaely reaing hem as pre-flow creaes an apparen correlaion wih nex-day marke movemens. The fac ha flows are uncorrelaed wih pos-9 PM marke movemens (and he regression coefficiens are precisely esimaed) suggess ha his is no he source of he relaively srong correlaion wih 4:15 o 9 PM marke movemens. 18 A second possibiliy is insider rading, e.g. a echnology CFO buying a ech fund prior o a posiive earnings surprise raher han buying company sock. As a es of wheher his was an imporan source of he correlaion, I reesimaed Table I excluding he period 10 o 45 days afer he end of he calendar quarer when over 75 percen of COMPUSTAT firms announce quarerly earnings. The coefficien excluding his period was no significanly differen. A hird possibiliy is ha he causaliy runs in he oher direcion: muual fund inflows lead o an increase in he sock marke. The iming of he correlaions does no fi well wih his explanaion; he sory would have o be ha flows hrough inermediaries ha ge invesed he following day are fron run by people who learn abou hem beween 4 and 9 PM. This explanaion also does no fi well wih he fac ha he sronges correlaion is beween inernaional fund inflows and pos-4 PM movemens in he S&P 18 In addiion, I replicae he family-level ess for correlaions wih pos-9 PM nex-day marke reurns conduced in Zizewiz (2003) and again find ha he null hypohesis of no correlaion is rejeced only a raes ha approximae he significance level of he es. Especially for inernaional funds, where i is now acknowledged ha sale price arbirage was commonplace, his suggess ha he flow daa is no inappropriaely lagged. 16

17 500. If reverse causaliy were he source of he correlaion, regressing 4:15 o 9 PM S&P 500 reurns on he esimaed dollar value of inflows ino inernaional and domesic equiy funds would capure his relaionship. When I do his, I ge a negaive and saisically insignifican coefficien on domesic fund inflows. The coefficien on inernaional fund inflows suggess ha a $1 billion inflow causes a 32 basis poin appreciaion in he S&P 500, which is an implausibly large effec by several orders of magniude. V. Discussion This paper presens evidence ha muual fund rades supposedly placed before 4 PM are correlaed wih marke movemens from 4 o 9 PM, and argues ha illegal lae rading is he likely source of he correlaion. Trading muual funds using pos-4 PM informaion earns profis for he arbirageurs, bu coss long-erm shareholders an annual average of 3.8 and 0.9 basis poins from in inernaional and domesic equiy funds, respecively. Assuming his diluion rae prevails hroughou he indusry, his would imply annual losses of abou $400 million. While he amoun of long-erm shareholder wealh los due o lae rading is large in absolue dollar erms, i is small relaive o ha los o marke iming. I is also probably smaller han he impac of oher issues ha are now receiving scruiny, such as excess rading due o incenives creaed by sof dollars and invesors of choosing high-expense-raio funds. Bu charging a high expense raio for an index fund, overrading o earn sof dollars, and even allowing marke iming are no illegal, whereas allowing lae rading is. Lae rading is hus suggesive of a differen kind of oversigh and agency problem wihin 17

18 muual funds han hese oher pracices. Undersanding he exen o which he muual fund indusry engaged in illegal aciviy ha harmed shareholders is of firs-order imporance in undersanding he degree of agency problems in he indusry. On he posiive side, he exen of lae rading appears o have dropped sharply since Sepember In addiion, policy proposals are now being considered ha will likely make lae rading more difficul o execue. Among hese is he so-called hard close, which would require orders o be received by he fund or is ransfer agen by 4 PM, eliminaing he possibiliy for inermediaries o add or cancel orders afer 4 PM. Even if his rule is pu in place, however, i is unlikely ha any sysem will be compleely immune o abuse. Hopefully, he fairly simple empirical echniques used in his paper will provide a mehod for fund managers, rusees, and regulaors o monior for lae rading in he fuure. 18

19 References Baumol, William, Sephen Goldfeld, Lilli Gordon, and Michael Koehn The Economics of Muual Fund Markes: Compeiion vs. Regulaion. Kluwer: Boson, MA. Bhargava, Rahul, Ann Bose, and David Dubofsky Exploiing Inernaional Sock Marke Correlaions wih Open-End Inernaional Muual Funds, Journal of Business, Finance, and Accouning 25, Boudoukh, Jacob, Mahew P. Richardson, Mari Subrahmanyam, and Rober F. Whielaw Sale Prices and Sraegies For Trading Muual Funds, Financial Analyss Journal 58, Bullard, Mercer Your Inernaional Fund May Have he Arbs Welcome Sign Ou, TheSree.Com (June 10). Buron, Jonahan Sudy Finds Lae Trading Widespread, CBSMarkewach.com (Sepember 11). Carnahan, Ira Looing Muual Funds, Forbes.com (March 19). Chalmers, John, Roger Edelen, and Gregory Kadlec On he Perils of Securiy Pricing by Financial Inermediaries: The Wildcard Opion in Transacing Muual Fund Shares, Journal of Finance 56, Chevalier, Judih and Glenn Ellison Risk aking by muual funds as a response o incenives, Journal of Poliical Economy 105, Ciccoello, Conrad, Roger Edelen, Jason Greene, and Charles Hodges Trading a Sale Prices Wih Modern Technology: Opions for Muual Funds in he Inerne Age, Virginia Journal of Law and Technology, Culer, Seven Tesimony Concerning Recen Aciviy o Comba Misconduc Relaing o Muual Funds Before he Senae Subcommiee on Financial Managemen, he Budge, and Inernaional Securiy, Commiee on Governmenal Affairs, (November 3). Gaspar, Jose-Miguel, Massimo Massa and Pedro Maos Favoriism in Muual Fund Families: Evdience on Sraegic Cross-Fund Subsidizaion. Insead mimeo. Goezmann, William, Zoran Ivkovic, and Geer Rouwenhors Day Trading Inernaional Muual Funds: Evidence and Policy Soluions, Journal of Financial and Quaniaive Analysis 36,

20 Greene, Jason and Charles Hodges The Diluion Impac of Daily Fund Flows on Open-End Muual Funds, Journal of Financial Economics 65, Hechinger, John Lae Trading of Funds Found Prevalen, Wall Sree Journal (Sepember 12). Horascu, Ali and Chad Syverson Search Coss, Produc Differeniaion, and he Welfare Effecs of Enry: The Case of S&P 500 Index Funds. Forhcoming, Quarerly Journal of Economics. Hulber, Mark Monioring Trades for he Good of he Fund, New York Times (April 9). Lucchei, Aaron Frequen Trading Worries Fund Firms, Wall Sree Journal (Sepember 22). Nelson, Sco B Lae Trading May Be More Widespread Than Though, Boson Globe (Sepember 12). Securiies and Exchange Commission Proecing Invesors: A Half Cenury of Invesmen Company Regulaion by he Division of Invesmen Managemen, Washingon D.C.: U.S. Governmen Prining Office. Siggelkow, Nicolaj Expense Shifing: An Empirical Sudy of Agency Coss in he Muual Fund Indusry. Wharon mimeo. Sae of New York v. Canary Capial Parners, LLC Complain. Sepember 3. Sewar, C. Evan The Sof 4 PM Brick Wall: A Realiy Check on Lae Trading, Money Managemen Execuive (March 22). Sone, Amey When Marke Timers Targe Funds, Business Week Online (December 11). Wells, David and David Wighon Broker Quesions Lae Trading Orhodoxy, Financial Times (April 6). Zizewiz, Eric Who Cares Abou Shareholders? Arbirage-proofing Muual Funds, Journal of Law, Economics, and Organizaion 19,

21 Table I. Correlaion of fund inflows wih pos-4pm marke movemens Dependen variable: flow()/asses(-1) S&P 500 fuures changes Weighing Obs. R^2 3 AM o 11:30 AM 11:30 AM o 4 PM 4:15 PM o 9 PM Inernaional equiy Equal *** (0.026) 0.459*** (0.024) 0.309*** (0.074) Asse *** (0.014) 0.301*** (0.015) 0.173*** (0.043) Foreign sock Equal *** (0.029) 0.531*** (0.032) 0.423*** (0.090) Asse *** (0.019) 0.403*** (0.021) 0.254*** (0.058) Asia/Japan/Europe sock Equal *** (0.066) 0.830*** (0.056) 0.593*** (0.172) Asse *** (0.063) 1.033*** (0.059) 0.434** (0.178) Global/Lain/EM sock Equal *** (0.025) 0.254*** (0.017) 0.102** (0.049) Asse *** (0.008) 0.136*** (0.008) 0.072*** (0.024) U.S. equiy Equal *** (0.007) 0.060*** (0.008) 0.061*** (0.017) Asse *** (0.005) 0.050*** (0.004) 0.039* (0.020) Large cap Equal *** (0.008) 0.044*** (0.010) 0.051*** (0.018) Asse *** (0.006) 0.035*** (0.004) (0.022) Mid cap Equal *** (0.009) 0.094*** (0.009) 0.044* (0.027) Asse *** (0.009) 0.104*** (0.008) 0.049** (0.021) Small cap Equal *** (0.011) 0.072*** (0.010) 0.107** (0.042) Asse *** (0.010) 0.069*** (0.008) 0.071*** (0.026) Technology funds Equal *** (0.099) 0.240*** (0.049) 0.184*** (0.058) Asse *** (0.035) 0.253*** (0.026) 0.355*** (0.080) Noes: 1. Each row is a regression of flows on S&P fuures changes for differen asse classes and weighing mehods. 2. Heeroskedasiciy-robus sandard errors in parenhesis. 3. Significance a 10, 5, and 1 percen level indicaed by 1, 2, and 3 aserisks, respecively.

22 Table II. Unil when does lae rading occur? Dependen variable Flow()/Asses(-1) Reurns(+1) Sandard deviaion of S&P changes Asse class Inernaional U.S. equiy All Inernaional U.S. equiy (in basis poins) Observaions R^ o 11:30 AM 0.368*** 0.056*** 0.212*** 0.217*** (0.026) (0.008) (0.015) (0.020) (0.015) 11:30 AM o 4 PM 0.473*** 0.064*** 0.268*** 0.348*** 0.083*** 93.8 (0.023) (0.009) (0.014) (0.020) (0.016) 4 o 4:15 PM 0.418*** 0.096*** 0.114* 0.516*** 0.695*** 23.0 (0.113) (0.035) (0.065) (0.067) (0.111) 4:15 o 5 PM 0.365*** 0.085*** 0.225*** 0.683*** 0.934*** 21.7 (0.103) (0.024) (0.056) (0.064) (0.054) 5 o 6 PM 0.269** 0.050* 0.160** 0.908*** 0.981*** 16.8 (0.118) (0.028) (0.064) (0.092) (0.071) 6 o 7 PM *** 1.044*** 10.6 (0.186) (0.040) (0.103) (0.156) (0.102) 7 o 8 PM * 0.209* 0.955*** 0.783*** 9.1 (0.210) (0.058) (0.122) (0.179) (0.122) 8 o 9 PM *** 0.823*** 9.7 (0.221) (0.054) (0.122) (0.242) (0.165) 9 PM o 3 AM (+1) *** 1.059*** 24.8 (0.098) (0.030) (0.052) (0.118) (0.050) 3 o 11:30 AM (+1) *** 0.980*** (0.024) (0.009) (0.014) (0.022) (0.014) 11:30 AM o 4 PM (+1) *** 0.908*** (0.025) (0.007) (0.014) (0.019) (0.016) Noes: 1. Each column is a regression of flows or reurns on S&P fuures changes for differen ime periods. 2. Heeroskedasiciy-robus sandard errors in parenhesis. 3. Significance a 10, 5, and 1 percen level indicaed by 1, 2, and 3 aserisks, respecively.

23 Table III. Theoreical profiabiliy of sale price arbirage, lae rading, and he wo sraegies in andem Annualized excess reurns versus buy-and-hold sraegy wih comparable exposure o same funds Sraegy pursued Asse class Sale price arbirage Lae rading Boh All inernaional equiy 37.1*** 8.5** 40.3*** (4.2) (3.6) (4.4) All domesic equiy * 13.6** (5.7) (5.6) (5.8) Domesic echnology funds ** 20.9*** (7.8) (7.7) (7.9) Noes: Annualized excess reurns are measured as in Zizewiz (2003): a maximum frequency rading sraegy is assumed in which he rader holds he equal-weighed average fund if expeced nex-day reurns are posiive and cash oherwise. Expeced reurns are esimaed using he model in Table I for he wo prior years (for domesic equiy funds, S&P changes from 2 o 3 PM and 3 o 4 PM are subsiued as he pre-4pm predicive variables). Reurns are compared wih a sraegy of buying and holding he fund and cash in proporions ha yields he same average exposure o he fund. Heeroskedasiciy-robus sandard errors are in parenhesis.

24 Table IV. Diluion due o lae rading by asse class Basis poins per year, Equal Value U.S. equiy 1.30*** 0.88** (0.34) (0.36) Large cap 0.95*** 0.51 (0.30) (0.35) Mid cap 0.94** 1.02*** (0.44) (0.38) Small cap 1.55*** 1.06*** (0.55) (0.37) Technology funds 6.74*** 13.45*** (1.95) (2.73) Inernaional equiy 6.27*** 3.77*** (1.57) (0.90) Foreign sock 6.05*** 3.80*** (1.25) (0.83) Asia/Japan/Europe sock 11.30*** 10.23*** (3.54) (3.83) Global/Lain/EM sock 2.36** 1.62*** (1.05) (0.52) Diluion is calculaed for each day using he formula in Equaion (3) in he ex and he model in Table II (including variables hrough 9 PM). The heeroskedasiciy-robus sandard error is from a regression of hese 1,076 daily diluion figures on a consan.

25 Table V. Diluion due o lae rading by year Basis poins per year U.S. Equiy Inernaional equiy Year Equal Value Equal Value ** 1.17** 11.68** 5.66** (1.00) (0.73) (4.32) (2.23) *** 1.23*** 7.35*** 4.24*** (1.03) (0.61) (3.30) (2.03) * (0.66) (1.67) (4.65) (1.96) *** 1.41*** 12.68*** 7.88*** (0.69) (0.63) (3.91) (2.45) * (0.82) (0.53) (3.67) (2.66) 2003 (Jan-Aug) 0.87*** 1.09*** 4.12*** 3.23*** (0.33) (0.30) (3.01) (1.69) 2003 (Sep-Dec) (3.17) (0.22) (0.81) (0.79) 1998 o *** 0.88*** 6.27*** 3.77*** (0.34) (0.36) (1.57) (0.90) Diluion is calculaed for each day using he formula in Equaion (3) in he ex and he model in Table II (including variables hrough 9 PM). The heeroskedasiciy-robus sandard error is from a regression of hese 1,076 daily diluion figures on ime period dummies.

26 Figure 1. Non-parameric esimae of lae rading Technology funds Inernaional equiy Domesic equiy 4.5% 4.0% 3.5% Equal-weighed inflow-o-asses raio -4.5 % -4.0 % -3.5 % -3.0 % -2.5 % -2.0 % -1.5 % -1.0 % 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% % 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% -0.5% % -1.0% -1.5% S&P change, 4:15 o 9 PM Univariae kernel regression using daily equal-weighed inflow-o-asses raio for each asse class as a dependen variable. Regressions use a Gaussian kernel wih a bandwidh of 25 basis poins.