One day in late July, the telephone rang in the office of , a 32-year-old assistant professor of strategic management at the Stanford Graduate School of Business. He was busy. A bit distracted, he picked up the phone.
The caller was David D. Brown IV, a former lawyer at Goldman Sachs who had just started working for Eliot Spitzer, the New York attorney general. Mr. Brown was investigating improper trading practices in the mutual fund industry and had come across a provocative two-year-old paper by Professor Zitzewitz. It quantified the financial damage that some of these trading practices were inflicting on long-term fund investors – damages that he estimated at almost $5 billion a year.
That short conversation was the prologue to what is turning out to be the most extraordinary year of Professor Zitzewitz’s career.
The investigation has ripened into a harvest of shame for the mutual fund industry. After his research was cited on Sept. 3 at Mr. Spitzer’s first news conference on the mutual fund investigation, Professor Zitzewitz was thrust into the spotlight.
Talk about right place, right time. As Professor Zitzewitz is the first to emphasize, academic figures with far longer résumés have documented similar problems in mutual fund trading practices for at least four years. (His own résumé includes a bachelor’s degree in economics from Harvard and a Ph.D. from the Massachusetts Institute of Technology; he is currently teaching at the Columbia Graduate School of Business.)
All the researchers identified the same phenomenon: because American mutual funds are priced once a day at 4 p.m., their per-share prices may become stale, particularly if they own foreign stocks that trade in European markets that have already closed for the day or in Asian markets, which have not yet reopened.
Since a gain today in the American markets tends to indicate a gain tomorrow in those foreign markets, investors can predict, with a high degree of accuracy, what will happen to that mutual fund price when it is revised at 4 p.m. tomorrow. If they can move quickly in and out of that fund, they can capture a share of the profits that would otherwise have belonged to its longer-term investors, whose money actually financed the investments that produced the profits. That basic strategy has been variously described as time-zone or stale-price arbitrage, and its impact on other shareholders is known as dilution.
This research spurred little effective response until Mr. Brown, who is now chief of the attorney general’s investor protection bureau, began studying it. He had embarked on a crash course in the mysteries of mutual funds, which in his view had become “an open joke” on Wall Street, “a product for people who weren’t smart enough” to know that their pockets were being picked by the in-and-out traders.