Active Mutual Fund Traders Hamper Long-Term Investor Profits

Released: 7/2/2002 12:00 AM EDT
Source Newsroom: Georgia State University, J. Mack Robinson College of Business
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Citations J. of Financial Economics, Jul-2002 (Jul-2002)

Mutual funds are considered by most to be a long-term investment. But a new study in an upcoming issue of the Journal of Financial Economics has found that some investors are actively trading international funds resulting in profits for the short-term investor while having a negative impact on the overall fund and long-term shareholder profits.

"The impact on a fund is quite significant, " said Jason Greene, assistant professor of finance at Georgia State University's Robinson College of Business and co-author (with Charles Hodges, also with Robinson College) of The Dilution Impact of Daily Fund Flows on Open-End Mutual Funds. "Based on our study, we estimate the overall transfer of wealth from passive (long-term) shareholders to active traders to be more than $420 million."

According to the research, many open-end mutual funds provide virtually free and unlimited liquidity to those who wish to buy or redeem fund shares. The fund itself must either engage in costly trade or alter its cash position in response to the exchanges of mutual fund traders. In effect, the active trader imposes costs on the fund, which get passed on to the fund's passive shareholders. Active mutual fund traders contribute cash that is pooled with the mutual fund's existing risky assets. Once traders are "in" the fund, they receive the pooled risky return -- the same as other shareholders. If traders can accurately predict the future returns to the fund's risky assets, they can capture the price swings in these assets without incurring a cost. Such traders dilute short-lived positive returns (and concentrate negative returns) with cash.

This "dilution impact" affects open-end international mutual funds more so than domestic funds because traders are more accurately able to predict price swings in the overseas markets based on timing strategies. Green and Hodges' study show how active traders use stale prices in the overseas market to strategically trade in and out of international funds to take advantage of short-term market returns that follow U.S. market movements.

"The stale prices give rise to profitable trading strategies in which active traders can earn abnormal returns of 10% to 20% annually," added Green.

Green and Hodges conclude that while many current fund policies are aimed at thwarting diluting fund flows, they fail to significantly lower the dilution impact.

"Given that mutual funds are typically viewed and marketed as long-term investment vehicles, the mutual fund industry should carefully consider how exchange and pricing policies can affect investor welfare," says Green.

The J. Mack Robinson College of Business is one of the nation's top business schools. The College's Flex (part-time) MBA program has been listed in the top ten by U.S. News for the past seven years. Business Week magazine ranked the College's Executive MBA program 20th in the world and Forbes rated Robinson in the top 20 for return on investment for regional schools. Success Magazine ranks the College's entrepreneurship program among the top 50 in the nation. Georgia State University's Robinson College of Business has an enrollment of more than 8000 students and is located in downtown Atlanta.


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