Stale Prices and Strategies for Trading Mutual Funds

We demonstrate that an institutional feature of numerous mutual funds—funds managing billions in assets—generates fund net asset values that reflect stale prices. Because investors can trade at these NAVs with limited transaction costs in many cases, obvious trading opportunities exist. These opportunities are especially prevalent in funds that buy Japanese or European equities. Simple, feasible strategies generate Sharpe ratios (excess return divided by standard deviation) that are many times greater than the Sharpe ratio of the underlying fund. We illustrate the potential of the strategy for three Vanguard Group mutual funds. A particular issue to keep in mind is that when the strategies are implemented, the gains from these strategies are matched by offsetting losses incurred by buy-and-hold investors in these funds. In the past few years, the financial press has produced numerous articles about large cash flows into and out of certain mutual funds over short time periods. Most of the funds have had one major identifying characteristic: They invest in international—that is, non-U.S.—assets. We attempted to explain this phenomenon and documented the performance of trading strategies that are consistent with these fund flows.Two key institutional features underlie the trading strategies that lead to the rapid in-and-out trading. First, with the proliferation of mutual funds, a U.S. investor can buy into and exchange out of no-load mutual funds at essentially zero cost. Moreover, the opportunities abound; approximately 700 no-load mutual funds invest in international equities, and a number of them are very large. For example, at least 25 international equity funds have assets under management exceeding $1 billion.The second institutional feature is that when U.S. investors buy/sell mutual funds during the day, they do so at the prices prevailing at the close of trading in the United States. Those prices are based on the last transaction prices of the stocks in the fund. For Japanese and other Asian equities, the last transaction could have been at the previous 1:00 a.m. (U.S. Eastern Standard Time), and for many European equities, it could have been 12:00 noon. When these markets are closed, information flow does not cease; information relevant for valuation of the securities traded in the closed markets is still being released. For example, the literature contains considerable evidence that international equity returns are correlated at all times, even when one of the markets is closed. Moreover, the magnitude of the correlations may be quite large. This phenomenon induces large correlations between observed security prices during the U.S. trading day and the next day's return on these funds.In some cases, derivatives on international markets trading in the United States provide even more informative signals (than U.S. market returns) about the unobserved movements in the prices of securities in the non-U.S. equity funds. This knowledge can be used to generate considerable excess return in the buying and selling of mutual funds. With no transaction costs and perfect liquidity, an investor can purchase funds at stale prices. In the most extreme case, one can use 1:00 a.m. prices to buy a Japan fund while one has information about the “true” price some 15 hours later at 4:00 p.m.Given these facts, it is perhaps no surprise that we document extraordinarily high excess profits and Sharpe ratios for two categories of investment funds: Pacific/Japan equity funds and international/Europe equity funds. Our sample of funds was chosen for the staleness of their underlying prices, the size of the fund, and the ease of implementing the trading strategy. We studied a strategy of switching between a money market account and the underlying fund in response to signals during U.S. market hours. We also studied the effect of the various trading costs from various types of implementation procedures.Because mutual funds do place some limits on the frequency and amount of exchanges between funds, although the limits are not always enforced, we examined strategies with particularly strong signals. We found for both types of fund that, although the strategy recommended active trading only 5–10 percent of the time, the return, on average, substantially exceeded the return to a buy-and-hold strategy during an ex post very good market for equities. More interesting is the fact that for both types of fund, we could predict the next day's movement more than 75 percent of the time. Sharpe ratios generally ranged between 5 and 10 on the days the investor was in the market. The range of Sharpe ratios depended on whether the strategy included hedging of equity price movements during non-U.S. trading hours.To illustrate in a detailed manner the mechanics and results of the trading strategy, we provide a case study using three mutual funds from the Vanguard family of funds. This analysis is of special interest to academic readers because these funds are available through the retirement plans of numerous educational institutions and can be easily traded on the Internet or over the phone.