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“How widespread was late trading in

Mutual Funds?”

By Eric Zitzewitz

Brian Bannon

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Abstract:

In this report of the academic paper “How Widespread was Late Trading in Mutual Funds?

By Eric Zitzewitz, this was published in the American Economic Review 96 in 2006,

specifically his first draft. He released a later draft of the same paper with the inclusion of

more models and parameters but we will look at this paper at its current date of publication.

In the paper the author discusses the 2003 Mutual Fund Scandal in America, which was the

result of the discovery of illegal late trading and market timing practices on the part of

certain hedge fund and mutual fund companies. This was proven to be the result in the court

case against the banks involved. (New York State Vs. Canary Partners LLC, 2003).

From this the author takes data from previous years of trading after 4pm and correlates it

with market movements to see if this statistical method proves late trading effected the market

after 4pm. Furthermore the author repeated this test for different fund families, and for

different individual years to show the highs and lows of late trading and the extinction of it

after the 2003 investigations.

The author uses statistical methods to investigate his findings from the data provided. And

also investigates other possibilities behind these fluctuations in the market other than late

trading.

In this report, we set out to critically analysis this academic paper, by discussing the

importance of the paper and how it contributes to the research in the area of finance. Also

look at the methodology the author uses and whether was implemented correctly and

realistically, and whether the conclusions the author draws on are non-bias or subjective to

the topic the author is addressing.

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Introduction

• The aims of this academic paper?

In this paper the author sets out to investigate the 2003 Mutual fund Scandal in New York

America. The result of the discovery was illegal late trading and market timing practices

on the part of certain hedge fund and mutual fund companies. This was prohibited by the

Investment Act of 1940 (22c-1) and by the Securities Act of 1933. The investigation was

undertaken by the Securities and Exchange Commission (SEC). The SEC is charged with

the regulation of the mutual fund industry in the United States. The SEC claimed that

certain mutual fund companies alerted favoured customers or partners when one or more

of a company's funds planned to buy or sell a large stock position. The partner was then in

a position to trade shares of the stock in advance of the funds trading. Since mutual funds

tend to hold large positions in specific stocks, any large selling or buying by the fund often

impacts the value of the stock, from which the partner could stand to benefit. The portal of

which this was undertaken was late trading:

“Late trading refers to the practice of placing orders to buy or redeem mutual fund shares

after the time as of which a mutual fund has calculated its net asset value (NAV), usually

as of the close of trading at 4:00 p.m. Eastern Time, but receiving the price based on the

prior NAV already determined as of that day.”

(http://www.sec.gov/answers/latetrading.htm, 2014)

and market timing:

“Market Timing or “Stale price arbitrage” exploits the fact that many assets classes such

as international equities, trade in different time zones, the asset prices used to calculate

NAV’s at 4pm do not fully reflect recent market movements”

(Coyle, 2014)

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These procedures mainly happened in opened-ended mutual funds were shares could be

bought or redeemed at any point over the course of owning shares in the fund.

The author wants to investigate the extent of late trading in this sector by testing the trades

made from these funds before 4pm and after 4pm while also tracking the market movements

of a major index, i.e. FTSE100, S&P500, and to see if there is any correlation between the

timing of trades from mutual funds and fluctuations in the market index. From this the author

finds that a correlation exists between 4pm and 9pm but not post 9pm, which is stating that

the latest the trader would trade, would be 9pm.

Following this, assumptions were made on the annual losses to long term shareholders in

these funds from 1998 to 2003 with a drop in basis points of 3.8 and 0.9 basis points in

international and equity funds respectively, and an estimated $400 million per year loss to

shareholders.

The second aspect of mutual funds the author wished to investigate was the popularity of late

trading in the different fund families in the U.S.A.A test with these parameters showed

significant evidence that 39 out of the 66 fund families conducted late trading. Fund families

were usually aware of any high-frequency trading, and in some companies they had received

payments for allowing it directly or through sticky asset funds. The degree in which

companies where aware of late trading was never known. Some companies after the

investigation in 2003 came out and stated that they had knowledge of illegal late trading

while other used intermediaries such as stoke brokers etc. Intermediaries were used because

mutual funds usually allowed trades post 4pm, but this was abused and served purpose for

adding and deleting trades

Lastly, investigation into dilution of shareholder assets due to late trading was quite low in

percentage terms. Also the profitability of late trades, seeing only an increase in 3%, from

37% doing trading before 4pm, to 40% making trade decisions up until 9pm.

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• The source of the Authors data?

To test whether fund flows after 4 pm were correlating with market movements he used

daily data on fund assets, returns and distributions from TrimTabs and Lipper. TrimTabs

Investment Research, Inc. is an independent investment research firm based in Sausalito,

California, and The Lipper Mutual Fund Performance Analysis service provides mutual

and hedge fund data, analytical tools, and commentary. The data was collected from

February 1998 to December 2003 and March 2000 to December 2003 respectively from

the two firms. This data was restricted to equity and fixed income, since data is more

readily available for the market post 4pm.

An issue with both these sources of data is that the inflows are reported with a one day lag

for most of the funds. The author corrected this by treating each day’s assets figures as

pre flow rather than post flow.

The author’s choice of market index to map was a simplistic one. The author used the

near month future contracts from the Chicago Mercantile Exchange Time and Sales data.

The S&P 500 futures contracts contract trades from 4.45pm through to the following day,

for every trading day except Friday. The use of the Nasdaq 100 future for technology

funds and the Singapore Nikkei future opening price for Japan funds are better predictors

of next day returns but are not statistically significantly better indicators of inflows.

• Conclusions the author presented from the data?

A regression test on the data provided results to show measurement of late trading and

correlates the relation between daily mutual fund flows and market movements after

4pm.The dependent variable is the net inflows to the fund, where inflows are defined as

the difference between a fund’s current day assets and its prior day assets adjusted for

current day returns and distributions.

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Table1: Correlation of fund flows with post 4pm Market Table2: Dilution due to late trading by year (Basis points per year.) Movements.(Dependant Variable: Flow(t)/Assets(t-1)).

From Table 1 it provides strong correlation with market movements between 4pm and 6pm

and weak correlation for 6pm to 9pm.There is an absence of corellation after 9pm showing

9pm was the latest traders would leave a late trade to.The correlations were strongest in the

technology,international and small equity firms were violatility is high and NAV’s are stale.

The (dollar weighted) shares of the arbitrageurs who late trade is given by the ratio of

the coeffcients before and after 4pm. This suggests 57% of these dollars were being late

traded.The author assumes if the traders take into account the higher beta of international

market with respect to S&P500 after 4pm, he concludes that 30% of a traders dollars were

late traded.

There was a modest contribution to the profitability of late trading. For a trader trading a 4pm

into and out of international mutual funds there would have been returns of 37%, but if this

was extended to 9pm, there would be only a 3% increase to 40% on returns.

The same test was done again but this time including fund famlies. And found late trading in

40 out of 71 international funds, 13 out of 77 domestic funds, and with data on both assets

classes it was found that 39 of the 66 fund families tested positive for late trading in both

*Significant at

10% level.

**Significant

at 5% level

***Significant

at 1% level

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classes.The use of intermediaries was also a factor but the author added no eveidence for

this.It was discovered that 30% of the fund families in he authors sample were cited for late

trading by the regulator.

In Table2, the author does another regression test on the data to show the dilution of long

term shareholders due to late trading, which was the reduction in fund assets from apperent

late trades being priced at today’s and not tomorrow’s NAV.It shows that late trading drops

after September 2003 when the regulators started their investigations into late trading.His

dilution was largest in funds that reacted most to market movements, Asian, European, and

domestic technolgy funds.

Critical Analysis

• Discuss of Importance and Contribution to Reseach Area

I believe this paper added a lot to the area of late trading investigation from an acedamic

point of reference because it was he first of is kind to use a statisical analysis approach to

correlating trends of late trading within mutual funds. Before the 2003 mutual fund scandal

not much evidence was provided in this area. It was not till after 2003 when the SEC and

other regulators starting investigaing these illegal activites with their regulatory powers they

were able to gain information from inside the firms which was not made public, and still is

not available from most firms. The SEC were critised after the 2003 scandal for not doing

more in this area of mutal fund manipulation, (Untied States General Accounting Office,

2004).

This paper used clever statistical methods, and the information at hand to the author from

research firms i.e. TrimTabs,Lipper.He used the information of assests going into the funds

and out and matched this with market movements, which late traders use to gain advantage

and to make trades with additional information, post 4pm.

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Following on from this paper, not much other statistical methods have been used to report

late trading.Most of the information has been taken from the reports from the regulators,

published findings on major news blogs, (The Wall Street Journal score card, 2003) or from

the court case of 2003 where the majority of banks and institutions were cited. (New York

State Vs. Canary Partners LLC, 2003).

From this, analysts have used the information provided which covers a very narrow scope

and uses only a handful of the funds involved and does not cover most of the market. In

saying that this paper has limitations to the broadness of the data provided. But the author

uses most of the mutual funds listed in the 2001 Morningstar universe that have tickers. The

author even commented on the funds listed in the SEC November 2003 report,which stated

that 10% of the 88 mutual funds admitted to late trading, and concluded that 30 % of his

sample were from cited funds.

I believe this paper is well cited and has great motivation to develop this area of research, the

author draws from pools of acedamic research on the topics he has covered in this paper such

as dilution (Jason T. Green, 2006), and quotes many government bodies in this paper with up

to date regulation on the matter. (Testimony Concerning Recent Activity to Combat

Misconduct Relating to Mutual Funds, 2003).

I believe this paper covers a very essential gap in the research into late trading, the author has

come up with a clever statistical approach to showing evidence for late trading and a very

quick and simple way to monitor late trading in the future without requesting any information

from the funds in question, which in turn may be quite hard to obtain due to privacy laws.

• Discussion of the methology the author uses.

The authors approach to the methology of this topic is quite good he uses good resources and

and a proven method to the the correlation of the inflows to funds and market movements. He

purposes evidence of late trading and does not claim that this method is 100% proven just to

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justify that evidence of late trading exists from a statistical stand point.The paper is non-bias

or subjective saying that late trading is the only evidence for the 2003 scandal. He makes a

realistic assumption that late trading most likely was the main cause. At the end of the paper

he examines other options to cause the results from his data, such as insider trading, casuality

or the test itself.He scruntises these options with his statistical model and provides

information of why he believes them not to be the case.

He gives futher developments in the field of regulation and what is being done to combat this

illegal activity.One of these is the policy of “hard close” which requires orders to be received

by the fund or its transfer agent by 4pm eliminating the possibility for intermediaries to add

or cancel orders after 4pm. The author knows that late trading is not completely immue to

abuse but just hopes that through this simple emperical method, regulators or fund managers

can monitor late trading.

There are some disadvantages I found to this paper.I found the data sample to be too narrow.

The author only draws his information from two well know financial research companies and

for a very narrow timeline, from 1998 to 2003. I belive this timeline should be extended to

gather further information into late trading with inclusion of the 80’s and 90’s.Also not

limiting the data set to two.I believe more data from other research companies would povide

better sources to work from and better corelations.The author restricted himself to U.S. and

international equity funds in the communication and technoloy sectors. These parameters

should be broadened to include different sectors from a wide range of the market to gain a

better overall picture of late trading at an international scale.For the market movemets this

was also limited to the S&P 500 future contract trades. I would like to see how these equity

inflows to funds match up with European and other domestic markets in the U.S. and to see

what markets late traders were following the most.

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There were also some other limitations from the data set the author mentioned in this paper.

The author was unable to question the degree to which fund companies were aware of illegal

trading in their funds.Also he could not report on the existence of intermediaries in certain

trades whether the fund company gave the trade to a broker or the fund made the trade

themseleves.The author made an assumption of the reason why late traders engage in this

activity with such modest returns, such that they come from such large funds they are

compelled to trade in multiple assets classes, and international funds atract these kinds of

traders but this was not proven due to lack of evidence. But note the author brings these

limitations up in his paper, stating that this is not a perfect approach.

Lastly, I find some of the sources in this paper to be missing.The author uses quotes from the

regulatory bodies rulings on some of the points raised but does not cite them in this paper.

And on some of the calculations the author makes no effort to show were he got his numbers

such as “ If similar dilution rates prevailed outside this sample annual losses to late trading

would be approximately $400 million per year”, I would like to see the method on how the

author came to this conclusion.

• Reasearch Prosposal/Recommedations to further the paper.

As I mentioned before there has not been much work from a statistical point of view on

whether late trading was the cause of the 2003 scandal, so I can’t really compare this paper to

other statistical approaches to the problem.Now companies have come out and admitted to

this being the case in 2003, so now futher academic research is not needed on this matter the

public believes. The regulators have stepped in and have now elimanated late trading from

market. This is the general opinion in the market. I believe more models such as this one

stated in this paper should be carried out over large data sets to include large timescales, other

markets, comparing funds movements to different indicies.

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This model should be used by every regulator to check for crude signs of late trading, and

thus if the model shows positive signs of late trading the regulator can investigate further.

There is a very tractable theoretical framework there that can be developed for this model to

be implemented. The model is quite simple, and it addresses a very important problem in the

fund market whether shareholders in mutual funds are being taken advantage of by fund

managers.With more acedamic research done on this model better models with better initial

conditions and parameters could soon make late trading totally illegal in the market

place.Intermedairies could be punished for colaborating with lage mutual funds.

This I believe can only happen if the regulators or SEC pass legislation, and take hold of the

information from these funds , or have funds provide the authorities with all trade

information so a better statistical models for late trading can be made and elimanate late

trading from the market altogether.This will help make sure that shareholders in mutual funds

are not exploited and to regain trust in the mutual fund market for investors.

Conclusion

The author set out in this paper to provide evidence that late trading was the main cause for

the 2003 mutual fund scandal in America. Using statistical analysis of data provided from

reliable sources, the author has shown evidence that late trading is most likely the main cause

of this scandal. He went on to show that the diversity of late trading among the fund families

in the U.S. And the extent of dilution to shareholders and the drop off of late trading post

2003. The paper is well written with a clever idea of how to prove late trading existed in this

time period outside of information provided by government reports and court findings due to

privacy laws with the banks.

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Bibliography  (2003, November). Retrieved from The Wall Street Journal score card:

http://online.wsj.com/articles/SB106919765179559000

Cabe, P. M. (2009). The Economics of the Mutual Fund Trading Scandal. Finance and

Economics Discussion Series. Washington, D.C.

Coyle, C. (2014). Market Microstructure. In D. Coyle, Mutual Funds. Belfast.

Davis, G. F. (2009). Managed by the Markets: How Finance Re-Shaped America. New York

: Oxford Press.

http://www.sec.gov/answers/latetrading.htm. (2014, November). Retrieved from U.S.

Securities and Exchange Commission.

Jason T. Green, C. W. (2006). The Dilution Impact of Daily fund flows on open-end Mutual

funds. Journal of Financial Economics, 131-158.

(2003). New York State Vs. Canary Partners LLC. New York: State of New York.

Stephen Choi, M. K. (2006). The Market Penalty for Mutual Fund Scandals. New York: New

York University School of Law.

Testimony Concerning Recent Activity to Combat Misconduct Relating to Mutual Funds.

(2003). Washington D.C.: Us.Congress.Senate,Committee on Governmental

Affairs,Subcommittee on Financial Management.

Untied States General Accounting Office. (2004). Mutual Funds "SEC should modify propsed

regulations to address pension plans concern. Washington D.C.: Committee on Ways

and Means, House of Representatives.