With the issue of mutual fund trading practices under scrutiny in the U.S., one of the academics that has studied the issue of late trading suggests that funds with low costs are more likely to be defending the interests of unitholders , and less likely to be involved with dodgy trading.

Eric Zitzewitz, assistant professor of economics at Stanford University, has studied the issues of late trading and market timing by fund investors.

Recently, New York attorney general Eliot Spitzer brought the issue into the open with charges against a hedge fund, alleging that it engaged in these sorts of trading for its own gain and at the expense of long-term unitholders.

In an October 2002 paper, Zitzewitz found that the speed and efficacy of a “fund’s actions to protect shareholders from dilution is negatively correlated with its expense ratios and the share of insiders on its board, suggesting that agency problems may be the root cause of the arbitrage problem.”

He found that funds with lower expense ratios and fewer insiders on the board are more likely to have adopted short-term trading fees. “Both of these results are consistent with earlier adoption by funds with governance that places higher priority on shareholder welfare.”

In a more recent paper, Zitzewitz argues that, “While the amount of long-term shareholder wealth lost due to late trading is large in absolute dollar terms, it is small relative to that lost to market timing. It is also probably smaller than the impact of excess trading due to incentives created by soft dollars and smaller than the cost to investors of choosing high-expense-ratio index funds.” He estimates the annual shareholder losses due to late trading are about US$400 million.

However, he notes, charging a high expense ratio for an index fund, overtrading to earn soft dollars, and allowing market timing are not illegal, whereas allowing late trading is.

“Late trading is thus suggestive of a different kind of oversight and agency problem within mutual funds than these other practices. Understanding the extent to which the mutual fund industry engaged in illegal activity that harmed shareholders is of first-order importance in understanding the degree of agency problems in the industry. This is in turn informative about the extent to which policy should rely on the industry as a savings gathering vehicle.”