Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Sunday, May 18, 2008

Haslem on Mutual Fund Arbitrage

Mutual Fund Arbitrage and Other Practices: Sources of Explicit and Opportunity Costs, by JOHN A. HASLEM, University of Maryland - Robert H. Smith School of Business, was recently posted on SSRN.  Here is the abstract:

Mutual fund advisors often approve frequent trading arbitrage and late trading that may or may not be consistent with any specific limits on redemptions over a specific period of time. To increase advisor profits, these arrangements normally also require trader investment of "sticky assets" to "grow" fund assets.

However, these actions lower both actual and potential long-term shareholder returns. When this occurs, independent directors either have not been informed or they have acquiesced in the decision. In any case, independent directors have not performed their primary fiduciary duty as shareholder watchdogs.

In addition, mutual fund advisors engage in various other practices to increase their profits, again, knowingly at the price of lower long-term shareholder returns. These high cost practices include illegal "late trading" arbitrage; distribution and marketing (and advertising) costs, including 12b-1 fees; commissions and implicit trading costs plus "revenue sharing" payments to brokers for "shelf space," and other undisclosed practices; "soft dollar" commissions (and implicit trading costs) paid to brokers in return for research studies and data; increased brokerage commissions and implicit trading costs from larger trade sizes that further offset economies of scale; and high portfolio risk to boost annual returns to maintain shareholders and attract "performance chasers."

These costly mutual fund advisor practices reflect strong agency conflicts with shareholders that should be specifically prohibited. Independent directors need to assert control over advisor intentions and actions to allow these practices and provide disclosure for each. Disclosure should include complete normative transparency of disclosure to shareholders, independent director analysis of fund actions and behaviors relative to "best use" industry guidelines, and disclosure of all advisor intentions or decisions to use any practices that are costly to shareholder interests and returns.

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