Manager-Investor Conflicts in Mutual Funds

H alf of all of U.S. households own shares in one or more mutual funds, either directly or through personal or employer-sponsored retirement accounts. The growth in mutual fund investment has been dramatic. At the end of World War II, there were 73 mutual funds registered with the Securities and Exchange Commission holding $1.2 billion in assets (Investment Company Institute, 2003). By the end of 2002, over 8,000 mutual funds held more than $6 trillion in assets. Mutual funds own approximately 21 percent of the common equity and 11 percent of the debt securities of U.S. corporations (Federal Reserve, 2003). Table 1 shows the growth in the number and assets of mutual funds from 1992–2002. The existing literature on mutual funds focuses primarily on whether fund managers’ stock selection efforts generate excess returns that justify the associated fees and transaction costs (Daniel, Grinblatt, Titman and Wermers, 1997; Malkiel, 1995). In these studies, a mutual fund can be considered a black box that uses some strategy to convert investor cash into returns. But what happens inside the box has become front-page news. In July 2003, New York’s Attorney General, Eliot Spitzer, notified a hedge fund, Canary Capital Partners, LLC, that it was the target of an investigation into mutual fund trading practices. In early September, Spitzer alleged various trading improprieties in a civil suit against Canary. Suits and criminal prosecutions against other mutual fund traders, brokers, mutual fund management companies and their respective executives followed at a breakneck pace over the following months. Although the details of the alleged wrongdoings vary, the issues are all rooted