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Abstract: I examine the economic incentives behind the mutual fund trading scandal, which made headlines in late 2003 with news that several asset management companies had arranged to allow abusive--and, in some cases, illegal--trades in their mutual funds. Most of the gains from these trades went to the traders who pursued market-timing and late-trading strategies. The costs were largely borne by buy-and-hold investors, and, eventually, by the management companies themselves.

A puzzle emerges when one examines the scandal from the perspective of those management companies. In the short run, they collected additional fee revenue from arrangements allowing abusive trades. When those deals were revealed, investors redeemed shares en masse and revenues plummeted; management companies clearly made poor decisions, ex post. However, my analysis indicates that those arrangements were also uneconomic, ex ante, because--even if the management companies had expected never to be caught--estimated revenue from the deals fell well short of the present value of expected lost revenues due to poor performance in abused funds.

Why some of the mutual fund industry's largest firms chose to collude with abusive traders remains something of a mystery. I explore several possible explanations, including owner-manager conflicts of interest within management companies (between their shareholders and the executives who benefitted from short-term asset growth), but none fully resolves the puzzle. Management companies' decisions to allow abuses that harmed themselves as well as mutual fund shareholders convey a broader lesson, that shareholders, customers, and fiduciary clients be cautious about relying too heavily on firms' own self-interest to govern their behavior.

Keywords: Mutual fund, scandal, market timing, late trading, asset management, dilution, alpha

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