Introduction

In this chapter, we will explore the various undesirable trading behaviors that can occur at mutual funds, which can have significant impacts on the fund’s performance and its shareholders. These behaviors often exploit inefficiencies in the fund’s pricing and trading mechanisms, potentially harming long-term investors and undermining the fairness of the market.

Market Timing

Market timing is a trading strategy that attempts to profit from short-term fluctuations in the market. However, in the context of mutual funds, market timing refers to the practice of frequent buying and selling of mutual fund shares to take advantage of pricing discrepancies caused by delays in reflecting market movements in the fund’s net asset value (NAV).

Explanation

Mutual funds calculate their NAV at the end of each trading day based on the closing prices of their underlying securities. Investors may try to exploit this delay by buying shares at a price that does not fully reflect the current market value of the fund’s assets. They then quickly sell these shares at a higher price once the NAV catches up with the market.

Impact

Market timing can dilute the returns of long-term investors because it forces the fund to buy or sell assets at inopportune times. Additionally, it may lead to increased transaction costs and taxable gains for all shareholders, affecting their overall returns negatively.

Example

An investor observes that a mutual fund holds a significant portion of international stocks. After news of a positive economic development in the international market, the investor quickly purchases shares in the fund before the NAV reflects the market’s uptick. Once the NAV increases, the investor sells the shares to realize a quick profit.

Late Trading

Late trading is an illicit practice where investors place orders to buy or sell mutual fund shares after the market has closed but receive the NAV based on the previous day’s closing prices. This behavior is illegal and only benefits those engaging in it at the expense of other fund shareholders.

Explanation

Late trading takes advantage of time zone differences between different markets. For example, an investor in a U.S.-based mutual fund may learn of late-breaking positive news affecting overseas markets after the U.S. market has closed. They then place an order to buy mutual fund shares at the outdated NAV, giving them an unfair advantage over other investors.

Impact

Late trading can harm long-term investors as it dilutes the value of their holdings. Additionally, it disrupts the principle of fair pricing and undermines investor confidence in the mutual fund industry.

Example

An investor based in the U.S. hears about a significant positive development in Asian markets after the U.S. market has closed. The investor contacts a willing accomplice in a different time zone and places a late order to buy shares in a mutual fund that primarily invests in Asian equities. The accomplice enters the order with the previous day’s NAV, allowing the investor to benefit from the positive news before other investors can react.