On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option

Chalmers, John; Edelen, Roger M.; Kadlec, Gregory B.

doi:10.1111/0022-1082.00403

Cited by 109 publications

(60 citation statements)

References 35 publications

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“…For purposes of illustration, I am assuming in these first few paragraphs that the NAV accurately reflects the market value of the underlying portfolio. However, the mutual fund literature makes clear that this is not the case with some types of funds (e.g., Chalmers, Edelen, and Kadlec 2001;Goetzmann, Ivkovic, and Rouwenhorst 2001;Zitzewitz 2003).…”

Section: Editor's Notementioning

confidence: 99%

Inefficiencies in the Pricing of Exchange-Traded Funds

Petäjistö¹

2017

Financial Analysts Journal

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In late 2008, some investors spotted an attractive opportunity to buy municipal (muni) bonds or junk bonds, because both types of bonds had declined dramatically in value in the immediate aftermath of the Lehman Brothers collapse, arguably more than could be justified by realistic expectations of future defaults. Exchangetraded funds (ETFs) provided a convenient new vehicle for investors to take advantage of this opportunity: Any investor, including a retail investor, could easily buy a diversified portfolio of muni bonds or junk bonds, pay a low expense ratio, trade positions intraday, and use leverage to capitalize more aggressively on the opportunity. Efficiently executing such trades with ETFs, however, turned out to be more complicated.Two muni bond funds (tickers: PZA and MLN) both offered exposures to very similar portfolios of long-term muni bonds diversified across the entire United States. But with respect to their pricing, one was sometimes trading at a premium relative to its net asset value (NAV) whereas the other was trading at a discount at exactly the same time. The difference in the end-of-day premiums between the two funds varied from about +7% to -3% of NAV (Figure 1). Junk bond ETFs exhibited similar behavior, with the difference in premiums between the two largest funds (tickers: JNK and HYG) varying from +7% to -11% of NAV. The differences in premiums were driven by mean-reverting shocks to prices; that is, it was enormously important for an investor to correctly pick which fund to trade each day. Such pricing behavior was particularly surprising in the junk bond ETFs, given that each fund had several billion dollars Inefficiencies in the Pricing of Exchange-Traded FundsVolume 73 Number 1 cfapubs.org 25 in assets and traded large volumes every day with tight bid-ask spreads.Although the magnitudes in these examples are unusually large, 1 this article provides empirical evidence that smaller inefficiencies in the pricing of ETFs are not limited to a few funds or a particular period. In fact, the cross section of ETFs routinely exhibits some economically significant differences between the ETF share price and the value of the underlying portfolio, especially in some asset classes, indicating that the unsophisticated investor may face an unexpected additional cost when trading ETFs.Given the lack of attention that ETF premiums have received from investors, many of them appear implicitly to assume that ETF prices stay extremely close to NAVs. This assumption may be understandable because of the arbitrage mechanism that exists for ETFs: If the price is below the NAV, an arbitrageur can purchase ETF shares, redeem them for the underlying assets held in the ETF portfolio, and then sell the underlying assets at their prevailing market prices, which add up to the fund's NAV. 2 If the ETF price is higher than the NAV, an arbitrageur can do the reverse and create new ETF shares from the underlying assets. This action generates a pure arbitrage profit, minus the transaction costs of buying or sellin...

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Section: Editor's Notementioning

confidence: 99%

Inefficiencies in the Pricing of Exchange-Traded Funds

Petäjistö¹

2017

Financial Analysts Journal

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“…(1998), Bhargava and Dubofsky (2001), Chalmers et al (2001), Goetzmann et al (2001), Greene andHodges (2002), andZitzewitz (2003) point out that a simple trading rule using the S&P500 index returns as the signal to trade on international mutual funds can generate substantial profits. Given the overwhelming evidence on national stock market comovement, it is not surprising that returns on the S&P500 index can predict the over-night returns on foreign securities and as a result, a simple trading rule using the former to infer the latter turns out to be considerably profitable.…”

Section: Extant Vs Proposed Fair-pricing Approachesmentioning

confidence: 99%

“…See Bhargava et al (1998), Boudoukh et al (2002), Chalmers et al (2001), Goetzmann et al (2001), Greene and Hodges (2002), and Zitzewitz (2003). The issue has recently captured much regulatory attention.…”

Section: Introductionmentioning

confidence: 99%

Effective fair pricing of international mutual funds

Chua

Lai

2008

Journal of Banking & Finance

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We propose a new methodology to provide fair prices of international mutual funds by adjusting prices at the individual securities level using a comprehensive information set. Stepwise regressions are used to endogenously determine the stock-specific optimal set of instruments in estimating the fair price of each stock in a fund. We compare the performance of our approach with existing ones using 16 U.S.-based Japanese funds. Our method predicts significantly more accurately fund prices at next-day Japan open, which are the best proxies for the unobserved prices at U.S. close. The existing methods are shown to be highly vulnerable to speculative attacks while our method is the most successful in preventing such strategic exploitation in that no competing method can profit significantly from our stated price. Our method can profit from the existing methods significantly by between 23 to 80 percent annually. Simulation results show that our method is superior to existing ones regardless of the style of the funds, such as different turnover ratios, stock sizes, number of stocks in a fund, and book-to-market ratios.

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“…Chalmers et al (2001), Goetzmann et al (2001), and Zitzewitz (2003a), among others, all propose efficient pricing mechanisms that incorporate additional information available at the time NAVs are computed. This approach essentially leaves the NAV uncorrelated with market information.…”

Section: Fair Value Pricingmentioning

confidence: 99%

Fallout from the Mutual Fund Trading Scandal

Houge¹,

Wellman

2005

J Bus Ethics

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ABSTRACT. In September 2003, several prominent mutual fund companies came under investigation for illegal trading practices. Allegations suggested these funds allowed certain investors to profit from short-term trading schemes at the expense of other investors. Surprisingly, regulatory authorities have known for more than two decades of the potential for such abuses, yet have taken limited steps to correct the problem. We explore investor reaction to the scandal by measuring assets under management, stock returns, and performance. Mutual funds managed by investigated firms show a substantial decline in post-announcement assets under management. These firms also experienced significantly negative announcement-period returns. Finally, we discuss several policy suggestions to prevent future trading abuses and provide direction for future research.

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On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option

Cited by 109 publications

References 35 publications

Inefficiencies in the Pricing of Exchange-Traded Funds

Inefficiencies in the Pricing of Exchange-Traded Funds

Effective fair pricing of international mutual funds

Fallout from the Mutual Fund Trading Scandal

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