The Mutual Fund as a Firm: Frequent Trading, Fund Arbitrage, and the SEC's Response to the Mutual Fund Scandal

Since September 2003, the U.S. mutual fund industry has been mired in the worst scandal in its 65-year history. The scandal has produced in excess of 40 civil and criminal prosecutions, more than $2 billion in monetary sanctions, numerous Congressional hearings and bills, and a bevy of new regulations. Fund managers routinely permitted institutional traders to engage in fund arbitrage by allowing the arbitrageurs to buy fund shares at a discount and redeem them once the price had been corrected, with the traders' profits coming directly out of the pockets of other fund shareholders. The Securities and Commission has fundamentally misperceived the nature of the scandal, however, in focusing (1) its enforcement efforts on the frequent trading of fund shares, rather than on fund arbitrage, and (2) its rulemaking on how fund shares are purchased, rather than on how they are priced. The SEC's focus on cross-subsidization caused by frequent trading may undermine the viability of the mutual fund as a cooperative enterprise, or firm, while shareholders continue to be vulnerable to dilution of their investments by arbitrageurs. With $8.1 trillion in assets, mutual funds are Americans' investment vehicle of choice, and the creation of private Social Security accounts may further cement their dominant position in the financial services industry. The Commission should reverse course by strengthening pricing rules and withdrawing rules that interfere with the market's efficient regulation of cross-subsidization among mutual fund shareholders.