The Mutual Fund Scandal and Investor Response


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The mutual fund scandal was one of the biggest financial news stories of 2003 and the largest in the 65-year history of mutual funds. Many fund companies – totaling over one thousand funds and $1 trillion in assets - were investigated due to late trading and market timing allegations. This study is an empirical examination of the effects of the scandal in terms of consumer reaction, fund performance and industry reaction. Using ten years of data and a sample of thousands of mutual funds, we find that equity funds involved in a scandal outperformed their peers during the pre- and post-scandal periods, but significantly underperformed their peers during the scandal period, even after adjusting for market effects and fund characteristics, and in spite of increasing their risk profile. Our results find that funds involved in scandals experienced underperformed by over eighty basis points per year, indicating a meaningful and significant economic penalty for investors and fund families alike. Funds involved in scandals experienced significantly lower flows that have continued during the entire post-scandal period reviewed, mainly due to the reaction of retail investors, resulting in a deterioration of nearly 25% of the affected funds’ total net assets. We attribute this decrease in flows to an increase in monitoring costs for retail investors – a so called “scandal tax.” Funds involved in investigations that were announced later in the scandal period experienced less than half the decline from their investor base. We also find that retail investors continued to exit affected funds regardless of performance, unlike institutional investors who continued to invest in funds that performed well. Finally, we find that a subsequent reduction in expenses was significantly less effective in re-attracting flows to scandal funds than for their non-scandal counterparts.


Finance and Financial Management

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