Yale Bulletin and Calendar

October 3, 2003|Volume 32, Number 5

SOM professors' study on mutual
funds gets renewed notice

New York Attorney General Eliot Spitzer's investigation into fraudulent practices in the mutual fund industry -- and the resulting interest in fair value pricing as a means of combating arbitage -- has focused renewed attention on a study originally released by two professors from the Yale School of Management (SOM) in 2000.

The SOM study was the first to propose the fair valuation method that fund companies and regulators can employ to substantially reduce the opportunity to exploit the market timing and enable mutual funds to calculate more consistent and accurate daily net asset values (NAVs). The study was cited in Spitzer's formal complaint as one of the examples of academic research showing that trading abuses cost shareholders billions of dollars annually.

Titled "Day Trading International Mutual Funds: Evidence and Policy Solutions," the study was authored by SOM professors William Goetzmann and K. Geert Rouwenhorst along with Zoran Ivkovich, professor of finance at the University of Illinois.

In it, the professors analyze 391 U.S.-based open-end mutual funds that invest in foreign equities and examine the profitability of a simple day-trading strategy designed to take advantage of stale prices of international equity funds. For the period between 1990 and 1998 the results show that almost all international funds in the sample are vulnerable to stale pricing and speculative traders.

"Our research estimated that trading on stale prices in our sample mutual funds led to wealth transfers of about $1 billion per year between traders and long-term fund shareholders," according to Rouwenhorst, professor of finance and deputy director of the International Center for Finance at SOM.

Other studies have shown that the average investor is hurt by speculators who exploit the stale prices of mutual funds. Goetzmann and Rouwenhorst were the first to propose a simple methodology to increase the informational efficiency of end-of-day prices of mutual funds. In particular, the methodology is designed to incorporate information that becomes available during the U.S. trading day, but which is not used under the industry practice of using last transaction prices from foreign markets.

Since the paper's publication, the professors' methodology for determining end of day value for international mutual funds has gained widespread industry acceptance. Many mutual fund companies have begun to adopt some form of fair value pricing, and pricing service companies such as ITG and FT Interactive Data have cropped up to offer software solutions to help fund companies update the prices of foreign stock to reflect the market close.

Goetzmann and Rouwenhorst have studied fair value pricing, and other issues relevant to mutual fund settlements for the past decade. Being at the forefront of research on this subject hasn't been without its ethical dilemmas.

"When we originally wrote the paper in 1999, we sat on it for almost a year because we didn't believe it was ethical to release research that explains how to take advantage of the market," says Goetzmann, professor of finance and director of the International Center for Finance. "For this reason, we felt it was important to both quantify the problem and also propose a policy solution. We're pleased to see our fair value pricing method gain such acceptance within the industry."

More recently, the professors were also offered a chance to cash in on their research. "We were offered a chance to run a hedge fund with this [late trading] strategy, and we turned it down because of the ethics of exploiting regulatory loopholes. Apparently others did not have the same qualms," says Goetzmann.

The working paper, "Day Trading International Mutual Funds: Evidence and Policy Solutions" can be downloaded at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=217168.

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