Litigation and mutual-fund runs

(1)

ContentslistsavailableatScienceDirect

Journal

of

Financial

Stability

journalhomepage:www.elsevier.com/locate/jfstabil

Litigation

and

mutual-fund

runs

夽

Meijun

Qian

a

_,

_Bas¸ak

_Tanyeri

b,∗

a_Australian_National_University,_Wharton_Financial_Institutions_Center,_Australia b_Bilkent_University,_Turkey_and_MIT_Golub_Center_for_Finance_and_Policy,_USA

a

r

t

i

c

l

e

i

n

f

o

Articlehistory:

Received19February2015

Receivedinrevisedform16May2017 Accepted19May2017

Availableonline8June2017 JELclassiﬁcation: G23 G14 Keywords: Mutual-fundﬂows Litigation Returns

a

b

s

t

r

a

c

t

Weinvestigatewhetheranticipationofadverseevents(litigationaboutmarkettimingandlate trad-ing)maytriggermutual-fundruns.Wefindthatrunsstartasearlyasthreemonthspriortolitigation announcements.Pre-litigationrunsaccumulateto31basispointsofthetotalnetassetsovera three-monthwindow;post-litigationrunsmaylastmorethansixmonthsandaccumulateto1.25percentover thefirstthree-monthwindow.Additionally,investorswhorunbeforelitigationannouncementsearn significantlyhigherrisk-adjustedandpeer-adjustedreturnsthanthosewhorunafterlitigation.The dif-ferenceinreturnsisparticularlypronouncedforfundsholdingilliquidassets.Finally,securitiesheldby litigatedfundfamiliessignificantlyunderperformvis-á-visothersecuritiesintermsoflowerabnormal returnsandliquidity.Ouranalysissuggeststhatapro-rataownershipdesignisinsufficienttoprevent mutual-fundruns.

Introduction

Theﬁrst-come–ﬁrst-servedprinciplegoverningdeposit with-drawalsatparmotivatesbankruns:depositorswanttowithdraw beforeothersbecausethoseatthebackofthelinemaynotrecover theirdeposits(DiamondandDybvig,1983;ChariandJagannathan, 1988;Zhu,2005;ChenandHasan,2006,2008;DwyerandSamartin, 2009;Aldasoroand Faia, 2016).Incontrast, mutual funds allo-catetheproceedsfromassetsalesonapro-rata basis,a design thatshouldshieldthemfromruns.However,mutualfundsmay besusceptibletorunswhenadverseinformationaboutthe qual-ityofmanagement oraboutunderlyingassets isrevealed,even thoughthereisnophysicalqueueofcustomerswaitingto with-draw.Thispaperprovidesdirectevidenceofmutual-fundrunsboth beforeandafterrevelationofanadverseeventandinvestigatesthe motivationsbehindmutual-fundruns.

Wedeﬁneafundrunasanabnormallyconcertedredemption of mutual-fundshares in anticipationof, or afterrevelation of,

夽 TheauthorswouldliketothanktheeditorIftekharHassan,theanonymous referees,EdwardKane,WayneFerson,PhilStrahan,ItayGoldstein,anddiscussants attheFRCG2016,FMA2012,EFA2010,EFMA2008meetingsfortheirvaluable comments.

∗ Correspondingauthorat:FacultyofBusinessAdministration,BilkentUniversity. MITGolubCenterforFinanceandPolicy,Turkey.

E-mailaddresses:meijun.qian@anu.edu.au(M.Qian),basak@bilkent.edu.tr

(B.Tanyeri).

anadverseevent.Theadverseeventswe focusonarethe2003 and 2004litigationsalleging that certainmutual funds permit-tedsomeinvestorstoengagein latetradingormarkettiming,1

therebyallowingpreferentiallytreatedinvestorstoenjoyproﬁts attheexpenseofthoseinvestorswhodonotengageinsuch prac-tices.Whenshareholderssuspectorlearnthatfundmanagersdo notservetheinterestsofallinvestorsequally,thedisadvantaged investors may discipline the implicated funds by withdrawing existinginvestmentsand/orwithholdingnewinvestments.

Threereasonsmightmotivatefundrunsaroundlitigation.First, prior to litigation some investors may become aware of grey-area tradingpractices via the media, hence lose confidence in thequalityoffundmanagement andvotewiththeirfeet.These investors mayanticipate a possible futureindictment and thus decidetoexitbeforeitoccurs,creatingafirstwaveoffundruns. Second,afterlitigationannouncements,investorspenalize man-agement bywithdrawing theirinvestmentsand/orwithholding newinvestments,creatingasecondwaveofredemptions.Finally, post-litigation,funds may beforced tofire sale the underlying assetstomeettheconcertedwithdrawalsor,evenworse,to com-pletelyliquidatetheportfolios.Theprospectofafiresalemotivates investorstowithdrawearlytoavoidhavingtoredeemsharesat

1_Late_trading_is_the_purchase_or_sale_of_mutual-fund_shares_after_4:00_PM,_the_time

whenthenetassetvalue(NAV)isdetermined.Markettimingisshort-termtradingof mutual-fundsharestoexploitpriceinefﬁcienciesbetweenthemutual-fundshares andtheunderlyingsecuritiesinthefundportfolios.

http://dx.doi.org/10.1016/j.jfs.2017.05.011

(2)

undesirabletimes.Suchastrategiccomplementarityampliﬁesfund runs(Chenetal.,2010).

Inthispaper,wedocumentabnormaloutflowsbothbeforeand afterthelitigation,andinvestigatethemotivesforfundruns.To theextentthatinvestorsactoninformationleakedviathemedia, thereshouldbeabnormal fundoutflowswhen suchstories are published.Furthermore,ifinvestors runfundstopenalize man-agement,thesizeoftherunsshouldbelargerforfundsthatsuffer frompoorreputation.Finally,ifinvestorsareconcernedabout fire-salecosts,fundrunsshouldbemorecommonamongilliquidfunds thanamongliquidfunds.Moreover,ifthestrategic complemen-tarityhypothesisholds,investorswillbenefitbyredeemingshares beforesuchadverseinformationbecomespublic.Thatis,pre-event runsshouldearnrelativelyhigherreturnsthanpost-eventruns. Concertedredemptionsandthelackofnewsalesfollowing litiga-tionannouncementswillforcefundstoquicklyliquidateassets,and thislargetradingvolumemaytemporarilydepresstheunderlying assetprices.Becauseshareholderswhoredeemsharesatthistime willincurlosses,investorswhocananticipatelitigationsand sub-sequentredemptionshaveanincentivetoredeemsharesearly.By exitingearly,informedinvestorsavoidthefire-salecostscreated bythesubsequentconcertedwithdrawals.Therefore,the incen-tivesforearlyrunswillbegreaterforfundsinwhichthereturn differencesfromthetimingofthewithdrawalsarelarger,either becausetheyholdilliquidassetsorbecausetheirpoorreputations willdrivelargeoutflows.

Ourpaperempiricallyaddressesthefollowingquestions:First, dorunsoccurbothbefore(pre-event)andafter(post-event) litiga-tion?Second,doinvestorswhorunfundspriortolitigationavoid thecoststhatinvestorswhorunpostsufferfrom?Third,arefund runslargerforfundsthathavepoorerreputation?Fourth,arethe ﬁre-salecostslargerforfundswithilliquidassets?

Wefindthatfundrunstakeplacebothbeforeandafterthe lit-igation.Pre-eventrunsbeginasearlyasthreemonthsbeforethe litigation.First,inthethreemonthsbeforethelitigation,abnormal monthlyoutflowsfromtheinvestigatedfundsare31basispoints ofthetotalnetassets(TNA),andinthethreemonthsfollowingthe litigation,abnormaloutflowsare1.25percent.Second,investors whorunbeforethelitigationearnsignificantlyhigherrisk-adjusted andpeer-adjustedreturns(asmuchas6basispoints)thanthose whorunafterthelitigation.Thisdifferenceinreturnsismore pro-nouncedforlitigatedfundsholdingilliquidassets.Third,fundsare notequallyvulnerabletoruns.Fundsholdingilliquidassetsand stand-alonefundsexperiencelargeroutflows.

Ourresultsindicatethatmutual-fundinvestorswhoanticipate outflowsfollowing litigationnewshave incentives towithdraw earlytoavoid fire-salecosts.Weexaminetheabnormalreturns andtheliquidityoftheunderlyingsecuritiesheldbythe investi-gatedfundsaroundthetimeoflitigation.Illiquidstocksheldbythe investigatedfundssignificantlyunderperform(intermsof cumu-lativeabnormalreturnsfollowinglitigation)vis-à-visotherstocks. Furthermore,thebid-askspreadofilliquidstocksheldbythe inves-tigatedfundsalsoincreases.

Whenthetimingoftheaction(arun)mattersforthepayoff(the return),strategiccomplementarities(Bulowetal.,1985)comeinto play,whichamplifytheimpactofadverseeventsonthe fundamen-talsandgenerateﬁnancialfragility.Nonetheless,mutual-fundruns maynotoccurunlessthereisasystemicliquidityshocktoallfund investors(Chenetal.,2010).Intheabsenceofsuchashock,other investorswillpurchasetheassetsatﬁresalepricesandthus cor-rectthemispricing.2_{Consequently,}_although_there_is_a_fund_run,

2 _Chen_et_al.₍₂₀₀₈₎_show_that_hedge_funds_that_purchase_the_underlying_assets_of

mutualfundsatdepressedpricesduringfiresalesgeneratearbitrageprofitswitha similarmagnitudetotheprofitsofshortsellers.

investorswhoarenotmotivatedtoexitwillholdontotheirshares andsurvivetopricerecovery.Asaresult,mostoftheindictedfunds survive.Thedatarevealasurvivalrateof80percentforthe inves-tigatedfundsduringthe2003–2007period,whichissimilartothe averagemutual-fundsurvivalrateduringthesameperiod.

Theﬁnancial fragility of themutual-fundindustry is under-scoredbytheU.S. Treasury’sdecision toinsuretheholdings of eligiblemoney-marketmutualfundsinthewakeoftheturmoil causedbytherunontheReservePrimaryFundinSeptember2008.3

Ourﬁndingsnotonlyexplainwhymutualfundrunsmayoccur,but alsoenlightenonhowtheeventsthatledtothedemiseofReserve PrimaryFundreﬂectthefragilityoftheindustry.4

Despite the significance of fund market fragility, there is a scarcityresearchonmutual-fundruns.StrahanandTanyeri(2015) examinewhetherthemoney-marketfundsthatwerehitwiththe largestoutflowsfollowingtheReservePrimaryFundbreakingthe buckchangedtheirportfolioriskprofiles.Chenetal.(2010) inves-tigatethepayoffcomplementarityby analysingtheflow-return sensitivityofilliquidmutualfunds.Ourpaperdirectlydocuments runsandsilentrunsinmutualfundsbystudyingtheSpitzer inves-tigationsof2003and2004.Examiningaperiodpriortothe2008 crisisisimportantbecauseitshowcasesthevulnerabilityofmutual fundspriortothecrisis.Moreimportantly,weextendthe find-ingsofChenetal.(2010)bylookingataspecificadverseevent andprovidedirectevidenceofpayoffcomplementarityinmutual funds.

Theremainder of this article proceedsasfollows: Section 2 developsthemethodology;Section3describesthedata;Section 4outlinestheempiricalresults;andSection5presentsour conclu-sions.

2. Methodology

We address four research questions. First, do investors run investigated funds both before and afterlitigation? Second, do investorswho runfunds beforelitigationrealize higherreturns thanthosewhorunfundsafterlitigation?Third,aresometypes offundsmoresusceptibletorunsthanothers?Finally,arestocks thatareintheportfoliosoflitigatedfundsaffectedbytheilliquidity ofthemutualfundsthatholdthem?

2.1. Detectingpre-eventruns

Todocumentpre-eventruns,weneedbenchmarksofnormal flow,thefirstofwhichareflowstopeersnotnamedinthe2003 and2004lawsuits.Weconstructthreegroupsoffunds.Thefirst treatmentgroupcomprisesfundsnamedinthelitigations (inves-tigatedfunds);thesecondtreatmentgroupcomprisesfundsthat arenotnamedinthelitigationsperse,butaremanagedby com-paniesthatarenamedforotherfunds(otherfundsinfamilieswith investigatedfunds);thecontrolgroupcomprisesfundsmanagedby

3_The_U.S._Treasury_expressed_its_concerns_about_{uncertainties}_in_the

mutual-fundindustryandjustifieditsimplementationofaguaranteeprogramasfollows: “Maintainingconfidenceinthemoney-marketfundindustryiscriticaltoprotecting theintegrityandstabilityoftheglobalfinancialsystem....Thisactionshouldenhance marketconfidenceandalleviateinvestors’concernsabouttheabilityformoney marketmutualfundstoabsorbaloss....”(U.S.TreasuryDepartmentPressRelease, September19,2008).

4_Since_the_failure_of_Lehman_Brothers,_there_has_been_a_growing_body_of

litera-turestudyingthecausesandconsequencesofrunsinthemoney-marketindustry (McCabe,2010;KacperczykandSchnabl,2010,2013;ChernenkoandSunderam, 2014;Duca,2013;StrahanandTanyeri,2015).

(3)

companiesthatarenotinvolvedinlitigation(fundsinfamilieswith noinvestigatedfunds).5_We_then_compute_the_fund_ﬂows_as_follows:

Flowi,t = [TNAi,t−TNAi,t-1∗(1+ri,t)]/TNAi,t-1, (1)

whereFlow_i,tisthenetﬂowsoffundiinmontht,TNA_i,t_-1andTNAi,t

arethetotalnetassetsoffundiinmontht-1andt,respectively, andr_i,tisthereturnoffundiinmontht.Todetectwhetherthe implicatedfundshavelowerﬂowsthanthenon-implicatedfunds, wecomparethenetﬂowsofthethreegroupsbeforeandafterthe litigationdates

Thesecondbenchmarkfornormalflowsistheestimatednet flowsfroma modeldesignedtocapturethemaindeterminants of fundflows. We develop a model that includes variables for fundcharacteristics,pastreturns,andindustry-levelandstyle-level flows.Previousstudiesshowthatpastreturnswillpredictfuture flows(Gruber,1996;ChevalierandEllison,1997;SirriandTufano, 1998;DelGuercioandTkac,2002,2008)andthatindustry-level andstyle-levelflowsalsoexplainindividualfund-levelflows(Qian, 2011).Todetectpre-litigation and post-litigationruns,wealso constructevent-windowindicatorsandtestthefollowingmodel:

Flowi,t = a+

bj_∗_{fundcharacteristics} i,tj +

cj_∗_pastreturns ij+

dj∗aggregateﬂowstj+

j_∗_{Event-windowindicators} i,tj+εi,t, (2)

wherefundcharacteristicsaresize,thelogofTNA;age,thelog ofdays sincetheﬁrstofferdate; expenseratio,a fund’s operat-ingexpensesasaratioofthetotalinvestment;andmanagement fee, the management fee as a ratio of the average TNA. Past returnsincludecompoundedreturnsduringthepastone(R_i,t_-1),

three (

_s(1+ R_i,t_-_s)-1, s=1,2,3),and six months(

_s(1+R_i,t_-_s )-1,s=1,2,–-,6). Aggregateflowsare industry-leveland style-level flows:industry-levelflowsarethesumofflowsindollars(i(TNAi,t

−TNAi,t-1*(1+Ri,t)))toallfundsinthesampledividedbythesum

ofthelaggedTNA(i(TNAi,t-1)),andstyle-levelﬂowsarethesumof

flowsindollarstoallfundswiththesameinvestmentstyledivided bythesumofthelaggedTNA.Wedefineevent-windowindicators infourways.First,webenchmarkthefirstdatethatthefund liti-gationismentionedinthenewspaperstodefinethreeindicators: pre-litigation(−3,−1)forthethreemonthsbeforethelitigation newsdate;newsmonth(0)forthemonthofthelitigationnews; andpost-litigation(+1,+3)forthethreemonthsafterthe litiga-tionnews.Second,weidentifythedateofthelitigationfilingto definethethreeindicators:thepre-litigationfiling(−3,−1),the filingmonth(0),andthepost-litigationfiling(+1,+3).Third,we useboththelitigationnewsandthefilingdatestodefinethethree indicators: pre-litigationincludes themonthsbetweenthefirst newspaperarticleandthelitigationfilingmonth,thefilingmonth (0),andthepost-litigationfiling(+1,+3).Finally,thirteenindicators equal1ifitisthenthmonthfromthedateofthelitigationnews, otherwiseitis0(n=−6...−1,0,1...6).

2.2. Therationaleforpre-eventruns

Whatincentives existfor shareholderstorunamutual fund whenproceedsfromassetsalesaredeterminedbythepricesof theunderlyingassetsandaredistributedpro-rata?First,litigation

5_When_the_ﬁrst_newspaper_article_appeared_on_September_3,₂₀₀₃_it_was_not

clearwhichfundswouldbenamedinthelitigation.Hence,theremayhavealso beenoutflowsfromthecontrolgroupduetothepossibilityoffutureinvolvement. Assuch,wemayunderestimatethemagnitudeoftheoutflowsobservedinthe investigatedfundsrelativetotheoutflowsofthecontrolgroupfunds.

mayindicatehowfaithfullyfundmanagersareservingthe inter-estsoftheinvestors.Hence,investorsmayredeemsharesassoon astheyareinformed,eitherpubliclyorprivately,thatthefundsare engaginginabusivepractices,suchasmarkettimingorlatetrading. Whenasufﬁcientnumberofinvestorslearnofthefund’sabusive behavior,arunmayensue.Shareholderswhoredeemsharesatthis pointconsequentlywillrealizenegativeabnormalreturnsbecause themutualfundsmustquicklyliquidateassetstosatisfytheshare redemptions,andthelargesellingvolumewilltemporarilydepress theunderlyingassetprices.

We benchmarknormal returnsusingfivereturnmodelsand introduceindicators(asdefinedintheflowmodels)forthe pre-andpost-eventmonthstoidentifythereturndifferencesbetween investors who withdraw beforeand after litigation. These five return models are the market model (Sharpe, 1964; Lintner, 1965), the market model withlagged market returns (Scholes andWilliams,1977),the3-factorFama-Frenchmodel(Famaand French,1992,1993),theFama-Frenchmodelwithafourthfactor thatcapturesmomentum(JegadeeshandTitman,1993;Carhart, 1997),andthemarketmodelwithafactorthatcapturesliquidity (PástorandStambaugh,2003):

ri,t =˛+ˇ∗rm.t +

˛n_{∗event-windowindicator}n₊_ε i,t, (3) ri,t =˛+ˇ1∗rm.t+ˇ2∗rm.t–1 +

˛n_{∗event-windowindicator}n₊_ε i,t, (4) ri,t =˛+

ˇj_∗_FF_tj₊

˛n_{∗event-windowindicator}n₊_ε i,t, (5) ri,t =˛+

ˇj_∗_FF_tj₊ 1∗MOMt +

˛n_{∗event-windowindicator}n₊_ε i,t, (6) ri,t =˛+ˇ∗rm.t+2∗LIQt +

˛n_{∗event-windowindicator}n₊_ε i,t. (7)

wherer_i,tistheexcessreturns(netoftherisk-freerate)offundiin montht,andrm.tistheexcessmarketreturninmontht.FFjincludes

marketreturns,size(SMB),andvalue(HML)factors;MOMisthe momentumfactor;andLIQistheliquidityfactor.

WeestimatetheflowandreturnofEqs.(2)through(7)intwo ways. First, werun pooledregressions usingthefull sampleof boththeinvestigatedfundsandthenon-investigatedfunds.Pooled regressionsincludefundandyear-monthfixedeffects.Second,we runfund-levelregressionsusingonlythesubsampleoflitigated funds.Thepooledregressionsareefficientinthattheypool infor-mationfromallofthefunds;however,theymayalsobeinefficient due to thefact that all fundcoefficients must be thesame. In fund-by-fundestimations,fundcoefficientsmayvarybuttheyare restrictedtoinformationonsinglefunds.

Wealsousedailyreturnstoexaminethereturnimpactofthe withdrawal.Werunpooledregressionsusingtheﬁveassetpricing models,Eqs.(3)–(7),atthedailyfundreturnlevelandincluding bothlitigatedfundsandnon-litigatedfunds.ri,tistheexcessreturns

(4)

(netoftherisk-freerate)offundiondayt,andrm.tistheexcess

mar-ketreturnondayt.Thepre-eventindicatorindicates[−20,−1]days beforethelitigationannouncement,andthepost-eventindicator indicates[1,20]daysaftertheactuallitigation.Theeventindicator indicatesthedaysbetweentheannouncementandthelitigation. Observationsofthelitigatedfundscoverthesethreeevent win-dows.Observationsofthenon-litigatedfundscoverthemaximum numberofcalendardaysofobservationsofalllitigatedfunds. 2.3. Theimpactoffundcharacteristicsandliquidityonfundﬂows andreturns

Pre-eventrunsaremotivatedbyworriesaboutpotential liti-gationandanticipationoftheliquidationcoststhatwillariseto satisfythepost-litigationredemptions.Hence,investordecisions torunareinfluencedbytheirbeliefaboutorawarenessofabusive behaviourand byfactorsthatwillincrease fire-salecosts. Wor-riesaboutpoorbehaviourareaffectedbythereputationofthe fundmanagement companyaswell asby theinvestors’ ability tocollectandprocessinformation.Wemeasurethefund reputa-tionusingtheownershipstructureanditshistoryofSECcharges. Investorsmayassumethatfundsinconglomeratefamilieswillbe lesslikelytoengageindishonestbehaviourbecausealossof repu-tationwillhurtboththefundinquestionaswellasotherbusinesses intheconglomerate.Hence,illicitbehaviourmayhavemore seri-ousconsequencesforconglomerates thanforfundfamilies that onlymanagemutualfunds.Moreover,conglomerates,especially thosewithcommercialbanksubsidiaries,havealargercapacityto copewithliquidityshocksthanstand-alonefunds.Therefore,they willbelesssusceptibletorunsmotivatedbyattemptstoavoidfire sales.Likewise,pastactionsmaypredictfuturedecisions.Investors mayassumethatfundswithnohistoryofaberrantbehaviourinthe pastwillbelesslikelytobehavepoorlyinthefuture.

Toinvestigatewhetherthecharacteristicsoffundsandinvestors inﬂuencethesusceptibilityoffundstopre-eventruns,wegenerate indicatorvariablesforthefollowingcharacteristics.The conglom-erateandchargehistoryindicatorsequal1ifthefundispartofa conglomerateand ifit hadbeensubjecttoanSECinvestigation withinthepasteightyears,respectively;otherwisetheyareequal to0.

Theeconomicrationaleforpre-eventrunsistheliquidationcost (thepricedepression)thatfundswillbearwhentheyareforcedto sellassetsuponrevelationofanadverseevent.Thisliquiditycost increaseswiththeilliquidityoftheunderlyingassetsaswellaswith thevolumeoftheredemptions.Henceinvestorsinfundswith illiq-uidassetshavestrongerincentivestorunbecausetheymayreap greaterbenefits.Wethereforeinvestigatetheimpactofunderlying assetliquidityontheincentivestorunandthebenefitsof run-ningearlybygeneratinganindicatorvariable(illiquid)forilliquid funds.Wecategorizefundsasilliquidbasedontheassetsinwhich theyinvestusingLipperobjectivecodes. Illiquidfundsinvestin small-capstocks,internationalequityandbonds,andasset-backed securities(Lipperobjectivecodes:corporatebondslow,derivative mortgages,growthorsmallormidcapequity,internationalbonds, andinternationalequity),whereasliquidfundsinvestinlarge-cap stocksandtreasurybills.6_A_second_liquidity_{classification}_uses_the

cashholdingsofthefunds.Whenwelimitthesampletodomestic equityfunds,wecanalsoapplyathirdliquidityclassiﬁcationthat computestheweightedaverageofthebid-askspreadofthe under-lyingstocksasofJune30,2003,(threemonthspriortotheﬁrst

6 _Lan_et_al.₍₂₀₁₅₎_,_in_a_{classiﬁcation}_of_mutual_funds_according_to_their

invest-menthorizons,ﬁndthatfundswithlong-terminvestmenthorizonsinvestinilliquid stocks.Shareredemptionsforfundswithlong-terminvestmenthorizonsandilliquid stockholdingsmayhavelargerimpactsonprice.

litigation).Thesetwoalternativeliquiditymeasuresclassifyfunds withabovethesamplemedianweightedaveragebid-askspreador belowthesamplemediancash-holdingratioasilliquidfunds.

Werunfund-by-fundﬂowsandreturnregressionsinthe sub-samplesofthefundsgroupedperSEClitigationhistory,whetherthe parentisaconglomerate,andtheilliquidityofthefundportfolio.7

Thefirststepestimatestheflowmodelsandthereturnmodels foreachfundusingtime-seriesobservations.Thecontrolvariables fortheflowmodelsincludetheaccumulatedreturnsinthepast one,three,andsixmonths,andtheindustry-levelandstyle-level flows,managementfees,expenseratio,size,age,andyear indi-cators.The control variables for the return modelsinclude the yearindicatorsandtherelevantreturnfactorsinthefivereturn models.Theexplanatoryvariablesincludethethreeindicatorsfor theseven months surroundingthe litigation (i.e.,three indica-torscoveringthelitigationmonth,threemonthsbeforeandthree monthsafter).Thesecondstepcomparestheestimatedflowsand therisk-adjustedreturnsinthecrosssection.Weinvestigatethe cross-sectionaldifferencesaccordingtofunds’SECchargehistory, ownershipstructure,andtheliquidityoftheirunderlyingassets. 2.4. Returnsandliquidityoftheunderlyingassets

Weanalysethereturnstotheunderlyingstocksintheportfolios oflitigatedfundstodirectlytestwhethermutualfundsbearthe costsassociatedwithliquidatingportfoliopositions.Wecompile theholdingsofthelitigatedandthenon-litigatedfunds surround-ingalltheeventmonths,fromSeptember2003toMarch2004,and AugustandNovember2004.Foreachlitigationevent,wecompute thecumulativeabnormalreturns(CARs)inthe[−3,3],[−3,10], [_−3,20],[_−3,40],and[_−3,60]daysaroundthelitigationﬁlingfor allstockslistedontheCRSP.

The WRDS event study module estimates the market model—whichusestheCRSPequallyweightedportfolioasthe mar-ketportfolio—usingthedailyreturnsfrom282daysto30daysprior tothelitigationannouncement.Foreachstock,wealsoconstruct,% heldbylitigatedfunds,whichequalsthesharesofstockheldbythe litigatedfunds(inthatlitigationevent)overthetotaloutstanding shares.Theilliquidindicatorequals1ifthestocks’bid-askspreadis abovethemedianbid-askspreadofallthesamplestocks.Finally, weexaminehowtheinteractionbetweenlitigatedfundholdingsof thestockandilliquidity(interactionequallingthepercentageheld bythelitigatedfundsandtheilliquidityindicator)affectCARs.

Iftheﬁre-salepropositionholds,theliquidityofthe underly-ingassetsmayalsobeaffected.Weuseadifference-in-difference approachtoinvestigatethiseffect.Wecomputetheaverage bid-askspreadofeachstockforeacheventmonthaswellasforJune 2003.Wethenregressthedifferenceofthebid-askspreadbetween theeventmonthandJune2003on%heldbylitigatedfunds,illiquid indicator,andinteraction.

3. Data

Toidentifythefundsandthefundfamiliesnamedinthe market-timingandlate-tradinglitigations,weconductakeywordsearchin theFinancialTimesandtheWallStreetJournal.8_We_also_search_the

SEClitigationﬁlingsonEDGARandintheStanfordLawSchool Secu-ritiesClassActionClearinghouse.9_Table₁_summarizes_the_results

7_The_results_of_the_pooled_panel_regressions_of_ﬂows_and_returns,_available_upon

request,arequalitativelythesame.

8_We_use_three_{keywords—investigation,}_mutual_fund,_and_Spitzer—to_search_the

FinancialTimesandtheWallStreetJournalbetweenSeptember3,2003andDecember 31,2005.

9_The_Stanford_Law_School_Securities_Class_Action_{Clearinghouse}_(available_online

(5)

Table1

Listoffundfamiliesinvolvedintradingscandals.Table1liststhefundfamiliesnamedinlitigationsonmarkettimingandlatetrading.Hedgefunds,brokerageﬁrms,and investmentbankingservicesareexcluded.Litigationdataishand-collectedfromtheStanfordLawSchoolSecuritiesClearinghouseandSEClitigationnews.MTstandsfor markettimingandLTstandsforlatetrading.

Fundfamily Newspaperdate Litigationdate Settlement(inmillion$) Practiceunderinvestigation

NationsFundsTrustFamily 3-Sep-03 5-Sep-03 535 MT&LT

OneGroupFamily 3-Sep-03 9-Sep-03 90 MT&LT

JanusFamily 3-Sep-03 5-Sep-03 226 MT&LT

StrongFamily 3-Sep-03 5-Sep-03 175 MT

INVESCOFamily 3-Sep-03 31-Oct-03 415 MT&LT

PutnamFamily 3-Sep-03 21-Oct-03 194 MT

MFSFamily 8-Sep-03 11-Dec-03 350 MT&LT

AllianceBernsteinFamily 8-Sep-03 2-Oct-03 250 MT&LT

FederatedFamily 9-Sep-03 24-Oct-03 100 MT&LT

FranklinFamily 8-Oct-03 6-Feb-04 49 MT

AlgerFundsFamily 16-Oct-03 31-Oct-03 45 MT

SalomonSmithBarneyFamily 22-Oct-03 9-Aug-04 MT

ScudderFamily 5-Nov-03 22-Jan-04 208 MT

PBHGFamily 13-Nov-03 14-Nov-03 90 MT

ExcelsiorFamily 14-Nov-03 20-Nov-03 1 MT

ColumbiaFamily 14-Nov-03 13-Feb-04 460 MT

FremontFamily 21-Nov-03 12-Mar-04 4 MT

PIMCOFamily 13-Feb-04 20-Feb-04 90 MT

RSGrowthandValue 3-Mar-04 12-Nov-04 30 MT

AmericanFamily 24-Mar-04 24-Mar-04 MT

Sources:MoneyManagementExecutiveCompilation,January31,2004. FundScandalScorecard,WallStreetJournal,April27,2004.

SECPressReleases,September2003–December2004. FinancialTimes,2003–2005.

StanfordLawSchoolLibrarySecuritiesClassActionClearinghouse.

ofthissearch—includingthenamesofthefundfamilies;the

activ-itiesforwhichtheyareinvestigated;thelitigationannouncement

datesandthenewspaperannouncementdates;andthesettlement

inmilliondollars.WealsousetheStanfordClearinghousedatabase

toidentifythefundswithineachfundfamilythatareexplicitly

namedinthelitigation.

Aformalinvestigationintothetradingpracticesofmutual-fund

companiesbeganinSeptember2003,whenNew YorkAttorney

GeneralEliotSpitzerﬁledacomplaintintheNewYorkSupreme

Courtallegingthatthemutual-fundcompaniesofBankof

Amer-ica,BankOne,JanusCapitalGroup,andStrongCapitalManagement

hadallowedcertainhedgefundmanagerstoillegallytradeintheir

fundunits.Subsequently,betweenSeptember2003and August

2004,theSEC,theNewYorkStateAttorneyGeneral,andother

reg-ulatoryauthoritiesﬁledlitigationinvolvingfundsintwenty-ﬁve

mutual-fundfamilies.10

Newsarticlesonabusivetradingpracticesbymutualfunds pre-datethefirstlitigationannouncementinSeptember2003.Infact, theSECwasawareoffairpricingproblemsinmutualfundsasfar backas1997,andaprobeintohedgefundtradesthattook advan-tageofsuchproblemshadbeenunderwaysince 2002.Thefirst articleindicatingpossibleactiveinvolvementbymutual-fund man-agementisdatedMarch5,2003,andonMarch26,2003Congress beganconsideringoptionstostrengthenmutual-fundregulation.It ishighlyprobablethatbyMarch2003investorshadalreadybegun tosuspectabusivebehaviourandthepossibilityofacriminal inves-tigation.Thepre-eventindicatorsintheflowmodelsmaycapture whetherinvestors whosuspectedaberrantbehaviourredeemed theirsharespriortothelitigationannouncements.

Fortheuniverseofmutualfunds,werelyontheCRSP mutual-funddatabase(from WRDS),which providesmonthlyanddaily

prosecution,defense,andsettlementoffederalclass-actionsecuritiesfraud litiga-tion.

10_We_are_not_able_to_identify_the_names_of_the_individual_funds_investigated_in_ﬁve

ofthemutual-fundfamilies.Therefore,Table1andthesampleonlyincludetwenty mutual-fundfamilies.

observationsofthetotalnetassets(TNA)andreturns(R)offunds.11

ThesamplecoversthemonthsfromJanuary1999toDecember 2007.WemergethelistoflitigatedfundswiththeCRSPuniverseof fundstoproduceasampleinwhichtheinvestigatedfundsare dif-ferentiatedfromthenon-investigatedfunds.Weexcludeallfunds withmissingtickerandmanagementcodesymbols,fundsintheir incubationperiod,fundswithlessthansixmonthsofobservations aroundthelitigationdate,andfundswithaTNAoflessthan5 mil-lionUSD.WealsodropfundswithoutflowsgreaterthantheTNA andwithinflowsgreaterthanfivetimestheTNA.

PanelsA,B,andCofTable2provideasnapshotofthe sam-plefundsthree monthsbefore, duringthemonth of,and three monthsafterthe firstlitigationannouncement. Specifically,the panelsshowthenumberoffunds,themean,andtheaggregateTNA inthesubsampleoftheinvestigatedfunds,ofotherfundsinfamilies withinvestigatedfunds,andoffundsinfamilieswithno investi-gatedfunds.First,theaverageflowofinvestigatedfundsdecreased from1.1percentinJune2003to−0.2percentinSeptember2003. Similarly,theaverageflowofotherfundsintheinvestigated fam-iliesdecreasedfrom0.5percentto_−0.5percent.Furthermore,the negativeflowspersistedinDecember2003forbothgroups.The descriptivestatisticsindicatethattheinvestigatedfundssuffered outflowsintheeventmonthandbeyond.Theaverageinflowfor thecontrolgroup(fundsinfamilieswithnoinvestigatedfunds) droppedfrom1percentinJune2003to0.7percentinSeptember 2003,butitrecoveredto1.1percentinDecember2003.

The CRSP also providesinformation onfund characteristics, including the expense structure (management fees and expense ratio),investmentstyle,age(age),andthecashholdingsofeach fundrelativetotheTNA.Wealsohand-collectdataonthefund

11_Sampling_daily_ﬂows_would_be_ideal_to_document_fund_runs._However,_daily_ﬂow

dataareinferredfromthedailyfundsurveyoftheTNA.Thedailynetinﬂowondate tisthedifferencebetweenthefundTNAattheendofdaytandthefundTNAat theendofdayt–1,adjustedbythereturnondayt.Inthesurvey,somefundsreport theTNAoftandothersreporttheTNAoft–1onsurveydayt.Thesamefundmight reportaTNAoftonsomedaysandaTNAoft–1onotherdays.Thereisnowayto tracewhatandwhenfundsreport.Assuch,thedailyﬂowdataarenotreliable.

(6)

Table2

Summarystatistics:Overviewofsamplefunds.PanelsA,B,andCprovidesnapshotsofthreegroupsoffunds:(1)investigatedfunds,(2)otherfundsinfamilieswith investigatedfunds,and(3)fundsinfamiliesthatarenotinvestigatedasofJune,September,andDecember2003.Thetableliststhetotalnumberoffunds,theaverageTNA andtheﬂowofeachfund,andtheaggregateTNAandtheﬂowofallfundsinthethreegroups.

TreatmentGroup1: InvestigatedFunds

TreatmentGroup2:Other FundsinFamilieswith InvestigatedFunds

ControlGroup:Fundsin FamilieswithNo InvestigatedFunds PanelA:SnapshotonJune2003

Total#offunds 1560 1408 4769

AverageTNAofeachfund(million$) 738 313 485

TotalTNA(million$) 1,151,025 440,262 2,315,065

Averageﬂowofeachfund(%) 1.1 0.5 1.0

Totalﬂow(million$) 5846 1454 16,735

PanelB:SnapshotonSeptember2003

Averageﬂowofeachfund(%) −0.2 −0.5 0.7

Totalﬂow(million$) −715 −945 12,347

PanelC:SnapshotonDecember2003

Averageﬂowofeachfund(%) −0.9 −0.2 1.1

Totalﬂow(million$) −4355 −4003 14,776

characteristics. We use SEC EDGAR ﬁlings and ﬁrm Web sites

todeterminewhethertheparentcompanyisaconglomerateor

anassetmanagementcompany,andtheSEClitigationﬁlingsto

checkwhetherthefundshada priorhistory ofSECcharges.To

estimatefundperformance,wecompilemonthlydataonmarket

returns(rm);therisk-freerate(rf);andthevalue(SMB),size(HML),

momentum(MOM),andliquidity(LIQ)factorsusingWRDS’s

Fama-French,momentum,andliquiditydatabases.

Wecreateacross-sectionaldatasetattheindividualstocklevel

coveringallthestockslistedontheCRSP.WeusetheWRDSevent

studyapplicationtocalculate7-day(−3,+3),14-day(−3,+10),

24-day(−3,+20),44-day(−3,+40),and64-day(−3,+60)cumulative

abnormalreturnsaroundeachlitigationﬁlingforeachstock.We

compilethebid-askspread(calculatedatthedailylevelastheask

minusthebiddividedbytheaverageofthebidandtheask)for

allCRSPstocks.Wecalculatetheaveragedailybid-askspreadin

themonthofeachlitigationﬁling(September2003throughMarch

2004,August 2004,andNovember2004) andtheaveragedaily

bid-askspreadinthemonthofJune 2003(threemonthsbefore

theﬁrstlitigationannouncement).Wedeﬁnetherelativebid-ask

spreadasthebid-askspreadofeachstockineacheventmonth

rel-ativetoitsbid-askspreadinJune2003(theevent-monthbid-ask

spreadminustheJune2003bid-askspread).Weclassifythestocks

asilliquidifthebid-askspreadofthestockwaslargerthanthe

medianbid-askspreadinJune3003.Wethenmaptheholdingsof

themutualfundsontotheCRSPstocks.Wecalculate%heldby

lit-igatedfundsasthenumberofsharesheldineacheventmonthby

thefundslitigatedinthatmonthdividedbythetotalnumberof

sharesoutstanding.

4. Empiricalresults

First,weinvestigatefundﬂowsbothbeforeandafterthe

lit-igationnews and the ﬁling dates. Second, we analysewhether

investors who run prior to the litigation announcements earn

higherrisk-adjustedreturnsthaninvestorswhorunpostthe

litiga-tionannouncements.Third,weexaminecross-sectionaldifferences

intheﬂowsoflitigatedfundsaccordingtotheliquidityofthe

secu-ritiesin which theyinvest.Fourth, we investigatewhetherthe

liquidityandabnormalreturnsofstocksthatthelitigatedfunds

holdareaffectedbytheliquiditysqueezeoftheirinvestors.

Fig.1. Time-seriestrendofaveragefundﬂows.

TheﬁgureplotsaveragemonthlyﬂowsfromSeptember2001toSeptember2005in threefundsubsamples:treatmentgrouponeconsistsofinvestigatedfunds, treat-mentgrouptwoisconsistsoffundsinfamilieswithinvestigatedfunds,andthe controlgroupconsistsoffundsinfamilieswithnoinvestigatedfunds.Flowi,tis

calculatedas[TNAi,t−TNAi,t-1*(1+Ri,t)]/TNAi,t-1.

4.1. Detectingpre-eventruns

Wedetectpre-eventrunsusingtwobenchmarks:aunivariate

analysistobenchmarktheﬂowsofinvestigatedfundsandother

fundsinthesamefamilyagainsttheﬂowsoffundsinfamilieswith

noinvestigatedfunds,andamultivariateanalysistobenchmarkthe

ﬂowsofinvestigatedfundsagainsttheﬂowsestimatedusingthe

normal-ﬂowmodel.Theaveragemonthlyﬂowsofthethree

sub-samplefundsfromSeptember2002toSeptember2004areplotted

inFig.1.Asthefigureshows,beforeJune2003theflowsof inves-tigatedfundsareeitherhigherthanornotdifferentfromtheflows offundsinfamilieswithnoinvestigatedfunds,butthereafterthey areconsistentlylower.Thatis,flowsshiftedthreemonthsbefore thefirstlitigationfiling,suggestingthatinvestorsranfundsboth beforeandafterthefirstlitigationannouncement.

Table3showstheaveragemonthlyﬂowsforthetwotreatment groupsandthecontrolgroupfromSeptember2002toSeptember

(7)

Table3

Acomparisonofflowsamongfundgroupsovertime.Thistableshowstheaveragemonthlyflowsforthethreefundgroups:investigatedfunds,otherfundsinfamilieswith investigatedfunds,andfundsinfamilieswithnoinvestigatedfundsfromSeptember2002toSeptember2004.Theeventmonthisthefirstmonthinwhichthelitigationwas announced(i.e.,September2003).Fundsinfamilieswithnoinvestigatedfundsareusedasbenchmarkstotestforflowdifferencesagainsttheinvestigatedfundsandother fundsinfamilieswithinvestigatedfunds.**and*denotesignificanceatthe1%and5%levels,respectively.

Monthsfrom September2003

Date TreatmentGroup1: InvestigatedFunds

TreatmentGroup2:Other FundsinFamilieswith InvestigatedFunds

ControlGroup:Fundsin FamilieswithnoInvestigated Funds

DifferenceinMeansTest

T-test (1) (2) (3) (1)=(3) (2)=(3) −12 Sep-02 1.02 0.56 0.38 [2.00]** [0.58] −11 Oct-02 0.39 −0.08 0.58 [−0.65] [−2.15]* −10 Nov-02 1.28 0.01 0.71 [1.81]* [−2.54]** −9 Dec-02 0.31 −0.53 0.16 [0.49] [2.43]** −8 Jan-03 0.53 −0.15 0.96 [−1.52] [−3.84]** −7 Feb-03 0.72 0.44 0.37 [1.99]* [0.29] −6 Mar-03 0.71 0.13 0.91 [−0.61] [−2.29]** −5 Apr-03 1.46 1.01 1.30 [0.51] [−0.91] −4 May-03 1.14 0.33 0.94 [0.72] [−2.19]** −3 Jun-03 1.07 0.50 1.05 [0.07] [−1.52] −2 Jul-03 0.63 0.10 0.86 [−0.72] [−2.38]** −1 Aug-03 0.03 0.23 0.89 [−3.07]** [−2.26]** 0 Sep-03 −0.22 −0.53 0.71 [−4.03]** [−5.20]** 1 Oct-03 0.37 0.56 1.31 [−2.66]** [−2.22]** 2 Nov-03 −0.76 0.90 0.95 [−8.39]** [−0.19] 3 Dec-03 −0.86 −0.22 1.11 [−6.56]** [−4.01]** 4 Jan-04 −0.10 0.54 1.75 [−5.97]** [−3.80]** 5 Feb-04 −0.37 0.66 1.32 [−7.09]** [−2.20]** 6 Mar-04 −0.53 0.32 1.01 [−4.35]** [−1.85]* 7 Apr-04 −0.67 0.14 0.72 [−5.70]** [−2.08]* 8 May-04 −1.52 −0.95 0.10 [−7.12]** [−4.42]** 9 Jun-04 −1.11 0.56 0.72 [−6.04]** [−0.44] 10 Jul-04 −0.90 −0.14 0.72 [−5.18]** [−2.54]** 11 Aug-04 −0.57 0.25 0.43 [−3.67]** [−0.61] 12 Sep-04 −0.82 0.40 0.37 [−6.16]** [0.10]

2004.TheresultsinTable3conﬁrmthevisualtrendinFig.1.Up

untiltwomonthspriortothefirstlitigationannouncement,the flowstotheinvestigatedfundsarelarger(orsmallerbut insignif-icant)thantheflowstothefundsinfamilieswithnoinvestigated funds.However,thistrendisreversedpriortoSeptember2003. Investigatedfundsthatenjoyedlargeflowsuptooneyearpriorto theonsetoflitigationbegantoexperiencerunsbeforeSeptember 2003andcontinuedtodosoafterSeptember2003.12_In_most_of_the

twelvemonthsfollowingSeptember2003,theflowsofthesecond treatmentgroup(otherfundsinfamilieswithinvestigatedfunds) arealsosignificantly lowerthantheflows ofthecontrolgroup (fundsinfamilieswithnoinvestigatedfunds).Theresultssuggest thatinvestorsmayseeinvolvementinlawsuitsasanindicatorthat fundfamilymanagershavefailedtoservetheinvestors’interests. Asa result,theywillpunishallfundsintheimplicatedfamilies regardlessofwhetherornotthefundinquestionallowedabusive practices.

Weinvestigatewhetherpre-eventoutflowsaredrivenby out-flowspriortothefirstlitigationinSeptember2003orbyoutflows fromfundsthatarelitigatedafterthefirstlitigation.First,we disag-gregatethelitigatedfundsintotwogroups.Thefirstgroupcovers litigatedfundsinthemonthsbeforethemonthoftheirlitigation filing(inthefirstspecification)andthenewsdate(inthesecond specification).Thesecondgroupcoverslitigatedfundsinthemonth ormonthsaftertheirlitigationfilingandthenewsdate.Second, wedifferentiatebetweeninstitutionalfundsversusretailfunds.

12 _This_pattern_of_lower_ﬂows_persists_more_than_two_years_after_the_event_month_in

non-tabulatedresults.Thelongertime-seriesofflowcomparisonsinnon-tabulated resultsalsoshowthatthesignificantflowdifferencesbetweentreatmentgroup 2andthecontrolgroupduringOctober2002andJanuary2003israndomrather thansystematic;therefore,thereisnoalternativehypothesistoexplainthelater systematicflowpatternsaroundthelitigation.

AppendicesA1andA2presenttheresults.Outﬂowsfollowingthe September2003litigationsaredrivennotonlybyfundslitigated inthatmonthbutalsobyfundsthatarelikelytobeimplicatedbut havenotyetfacedlitigation.Thetablealsoshowsthattheﬂow pat-ternsremainconsistentregardlessofthechoiceoftheeventdate. Retailinvestorsseemtobemoreresponsivetolitigation.

Table4reportstheresultsofthepooledregressionestimates fortheflowmodeldescribedinEquation(2).Monthlyflowsare regressedonindicatorsfortheevent-window(pre-event,theevent month, and post-event)and four setsof controls—fund charac-teristics, past returns, fee structures, and aggregate flows. The regressionsincludefundandyear-monthfixedeffects.Thethree specificationsdefinetheeventtimeusingthelitigationnewsdate, thefilingdate,andthewindowbetweenthenewsdateandthe liti-gationdate.Observationsareatthemonth-fundlevelandcoverthe monthsfromJanuary1999toDecember2007.Theregressionsuse cluster-robustvariance/covarianceestimatorsinwhichtheclusters arethefunds.

TheresultsinTable4confirmtheoutflowsduringandafterthe eventmonth,aspreviouslyindicatedinFig.1,Table3,AppendixA andB.Therearesignificantoutflowsfrominvestigatedfundsduring theeventmonth(−56basispointsoftheTNAinthesecond specifi-cation)andinthepost-eventperiod(−107basispointsoftheTNA inthesecondspecification).Funds,pastreturns,andaggregateflow controlsarealsosignificant.First,youngerandlargerfirmsenjoy significantlyhigherflowsthandotheirolderandsmaller counter-parts.Second,investorschasepastreturns.Third,fund-levelflows increase(decrease) significantlywithstyle-level(industry-level) flows.

Averagingapre-event periodmayglossover monthly varia-tionsinﬂowsduringeachmonth.Therefore,werunthepooled regressions with13 event-month indicators for the12 months surroundingthelitigationnews.AppendixBpresentstheresults. Therearefoursetsofcontrols—fundcharacteristics,pastreturns,

(8)

Table4

Detectingruns:Multivariateanalysisofmonthlyflows.Thetablerunsthreespecificationsoftheflowmodel:Flow=a+

bj*fundcharacteristicsj+

cj*pastreturnsj+

dj *aggregateﬂowsj+

␥j*Event-windowdummiesj+␧.ThedependentvariableiscomputedasFlowi,t=[TNAi,t−TNAi,t-1*(1+Ri,t)]/TNAi,t-1.Thepre-eventindicatorequals

1ifthefundislitigatedandthemonthfallswithinthreemonthsbeforetheevent;otherwiseitis0.Theevent-monthindicatorequals1ifthefundislitigatedandthemonth fallswithintheeventmonth;otherwiseitis0.Thepost-eventindicatorequals1ifthefundislitigatedandthemonthfallswithin3monthsaftertheevent;otherwiseit is0.Thefirstspecificationusesthenewspaperdatesastheeventdates.Thesecondspecificationusesthelitigationfilingdatesastheeventdates.Thethirdspecification usesthemonthsbetweenthenewsannouncementandthelitigationfilingasthepre-eventperiod.Fundcharacteristicsincludesize(thelogoftheTNAinmillionUSD),age (thelogofdayssincethefirstofferdate),theexpenseratio(thefund’soperatingexpensesasaratioofthetotalinvestment),andthemanagementfee(themanagementfee asaratiooftheaverageinvestment).Pastreturnsincludecumulativereturnsinthepastone,three,andsixmonths.Aggregateflowsincludeindustry-levelandstyle-level flows.Industry-levelflowsarethesumofflowsindollars(TNAi,t−TNAi,t-1*(1+Ri,t))toallfundsinthesampledividedbythesumofthelaggedTNA(TNAi,t-1).Style-level flowsarethesumofflowsindollarstoallthefundswiththesameinvestmentstyledividedbythesumofthelaggedTNA.Fundandyear-monthfixedeffectsareincluded. Observationsaremonthly(forbothlitigatedandnon-litigatedfunds)andtheycovertheperiodfromJanuary1999toDecember2007.Robustt-statisticsareinbrackets.* indicatessignificanceat5%and**indicatessignificanceat1%.

NewsDateas EventDate

LitigationFilingasEvent Date

TimebetweenNewsDate andLitigationFiling

Pre-event[−3,−1] −0.03 0.03 0.10 [0.29] [0.31] [0.85] EventMonth[0] −0.07 −0.56 −0.55 [0.45] [5.17]** [5.10]** Post-event[1,3] −0.91 −1.07 −1.06 [9.71]** [13.00]** [12.78]** Log(age) −2.68 −2.68 −2.68 [29.85]** [29.85]** [29.85]** Size 1.12 1.12 1.12 [23.38]** [23.39]** [23.38]** Returnin 0.03 0.03 0.03

thepast1month [6.60]** [6.60]** [6.60]**

CumulativeReturnin 0.01 0.01 0.01

thepast3months [3.53]** [3.54]** [3.53]**

CumulativeReturnin 0.06 0.06 0.06

thepast6months [26.98]** [26.99]** [27.00]**

ExpenseRatio 1.78 1.78 1.78 [8.02]** [8.03]** [8.03]** ManagementFee −2.06 −2.06 −2.06 [9.26]** [9.28]** [9.28]** Industry-NormalizedFlow −0.97 −0.97 −0.97 [10.81]** [10.81]** [10.81]** Style-NormalizedFlow 0.53 0.53 0.53 [22.09]** [22.07]** [22.08]** Constant −0.93 −0.93 −0.93 [2.24]* [2.25]* [2.25]*

FundFixedEffects Yes Yes Yes

Year-MonthFixedEffects Yes Yes Yes

#ofObservations 782,903 782,903 782,903

#ofUniqueFunds 10,463 10,463 10,463

R2 _2.81% _2.82% _2.82%

feestructures,andaggregateﬂows—andyearandfundﬁxedeffects.

Thetableshowssigniﬁcantoutﬂowsoftheinvestigatedfunds

start-ingasearlyasthreemonthspriortothelitigationannouncements,

andthesesigniﬁcantoutﬂowscontinuedduringthesixmonths

followingthelitigation.Thesizeoftherunsrangesfrom−52to

−88basispointsduringthemonthbeforethelitigation

announce-ment,andfrom−100to−122inthemonthfollowingthelitigation

announcement.Suchsigniﬁcantoutﬂowsindicatethat investors

runimplicatedfundsassoonastheysuspecttherewillbe

forth-cominglitigationinthecaseofpre-litigationoutﬂowsandassoon

aslitigationisﬁledinthecaseofpost-litigationoutﬂows.

4.2. Costsassociatedwithrunningearlyversuscostsassociated

withrunninglate

We also investigate what beneﬁts exist for investors who

runimplicatedfundspriortothelitigationannouncements.We

estimate models of normal returns to identify the return

dif-ferences to investigated funds in the months surrounding the

litigationannouncements.ThemonthlyreturnsfromJanuary1999

toDecember2007areregressedontheriskfactorsandtheindicator

variablesfortheevent-windowmonths,asdescribedinEquations

(3)through(7).Todetectthereturndifferences,wealsotestfor differencesinthecoefﬁcientsoftheevent-windowindicators.All regressionsusecluster-robustvariance-covarianceestimatorsin whichtheclustersaremutualfunds.

PanelAofTable5showsthatcoefficientsofpre-litigationand post-litigationindicatorsarenegativeandsignificant.Furthermore, investorswhoexitinvestigatedfundsafterthelitigation announce-mentsexperiencereturns8basispointslowerthaninvestorswho runbeforelitigation.PanelBshowsthatthedifferenceissignificant. Asintheregressionsforflows,averagingoverapre-eventperiod maymissthemonthlyvariationsin returns.InAppendixC,we runreturnregressionswith13event-monthindicators.PanelA ofAppendixCshows thatinvestorswhoruninvestigatedfunds afterlitigationannouncementsputupwithlowreturns.Indeed,the estimatesfromthemarketmodelindicatethatthecostofexiting investigatedfundsinthemonthfollowingalitigation announce-mentis52basispoints.Incontrast,investorsbenefitfromexiting investigatedfundsinthemonthpriortoalitigationannouncement. Theresultsofthefourotherreturnmodelsarequalitativelysimilar. OurresultsareconsistentwithCovalandStafford’s(2007) argu-mentthatthepricesofunderlyingassetsbecomedepressedwhen there isa largevolume of assetsales.Theresultsindicate that investorswhoexitimplicatedfundsbeforeotherinvestorsavoid lowerreturns.Table4 showsthat mutualfunds facelarge out-flowsfollowinglitigationandthustheymaysufferfire-salecosts whentheytrytoliquidatetheirportfoliostosatisfythehigh vol-umeofredemption.Thesefire-salecostsexplainthelowerreturns observedfollowingthelitigation.

PanelBofAppendixCanalyseswhetherinvestorsbeneﬁtfrom exitingimplicatedfundspriortolitigationannouncements.

(9)

Specif-Table5

Fundreturnsbeforeandafterlitigation.Pooledregressionsoffundreturnsonpricingfactorsusingthemarketmodel,Fama-French3-factormodel,Cahart4-factormodel, andmarketmodelswithlaggedreturnsandliquidityfactorsarerun.TheobservationsarefromJanuary1999toDecember2007.Thedependentvariableisthemonthlyfund returns(in%).Thepre-litigationindicatorequals1iftheobservationsfallwithin3monthspriortolitigationfiling;otherwiseitis0.Thelitigation-monthindicatorequals 1iftheobservationsfallinthelitigationmonth;otherwiseitis0.Thepost-litigationindicatorequals1iftheobservationsfallwithin3monthsafterlitigationfiling.Panel Apresentstheregressionresults.Thefundandyear-monthfixedeffectsareincluded.Theobservationsaremonthly(forboththelitigatedandthenon-litigatedfunds)and covertheperiodfromJanuary1999toDecember2007.Robustt-statisticsareinbrackets.*indicatessignificanceat5%and**indicatessignificanceat1%.PanelBtestsfor differencesbetweenthepre-litigationalphaandthepost-litigationalpha.

PanelA:Pooledregressionsoffundreturnsonpricingfactorsandlitigation-windowindicators MarketModel Fama-French

3-FactorModel

Carhart4-Factor Model

MarketModelwith LaggedReturns

MarketModelwith LiquidityFactor Pre-litigation(−3,−1) −0.14 −0.14 −0.14 −0.14 −0.15 [4.36]** [4.36]** [4.36]** [4.27]** [4.39]** Litigation-month(0) −0.18 −0.18 −0.18 −0.18 −0.18 [3.05]** [3.05]** [3.05]** [3.00]** [3.07]** Post-litigation(1,3) −0.23 −0.23 −0.23 −0.22 −0.23 [7.18]** [7.18]** [7.18]** [7.05]** [7.21]** MarketReturns 0.49 0.54 0.54 0.60 0.49 [63.74]** [83.45]** [80.94]** [92.58]** [71.34]** SMB 0.15 0.14 [35.55]** [36.42]** HML 0.04 0.04 [10.58]** [9.53]** Momentum 0.01 [5.50]**

LaggedMarketReturns 0.13

[54.82]**

LiquidityFactor 0.00

[0.78]

Intercept −0.49 −0.51 −0.56 0.13 −0.49

[16.12]** [17.11]** [21.14]** [5.96]** [16.21]**

FundFixedEffects Yes Yes Yes Yes Yes

Year-MonthFixedEffects Yes Yes Yes Yes Yes

#ofObservations 831,152 831,152 831,152 819,724 737,009

NumberofGroups 11,124 11,124 11,124 11,069 10,444

R2 _38.3% _38.3% _38.3% _38.5% _38.0%

PanelB:PerformanceDifference:Pre-litigation(−3,−1)indicator−post-litigation(1,3)indicator

Diff 0.08** 0.08** 0.08** 0.08** 008**

F-test [5.54] [5.54] [5.54] [5.43] [5.49]

p-value [0.02] [0.02] [0.02] [0.02] [0.02]

ically,theﬁrstrowslistthedifferencesbetweentheaccumulated

coefﬁcients of one to three months of event-month indicators

beforeandafterthelitigationannouncements.Thesecondrows

reporttheF-statisticsforthetestinwhichthedifferenceisequal

to0.For theone-monthwindow,thedifferenceinthe

market-modelcoefﬁcientsofthepre-andpost-announcementindicators

is70basis points,which isstatisticallysigniﬁcant.Forthe

two-monthwindow,theaccumulateddifferencesremainpositiveand

signiﬁcant.However,forthethree-monthwindow,the

accumu-lateddifferenceisnegative andmostly insigniﬁcant,suggesting

thatinvestors canavoid ﬁre-salelossesbyholdingthroughthe

ﬁre-saleperiodorbyexitingearly.

Theevidenceonthepre-eventrunsandthereturndifferences

suggeststhatthetimingoftheredemptionmattersforthereturns,

despitethepro-rata distributionof proceedsfrommutual-fund

assetsales.Furthermore,ifinvestors wanttopenalize

manage-ment,itisrationalforthemtodosobeforetheadverseinformation

becomespublic.

It iseconomically importanttoseethelong-term effects on

returns.We runregressionsonthemonthlyreturnsforthe

liti-gatedfundsandthenon-litigatedfundsusingthespeciﬁcationsin

Equations(3)through(7),addingyear-monthﬁxedindicatorsand

addinginteractionsforyear-monthindicatorsandlitigatedfund indicators.Theinteractions(foryear-monthandlitigatedfund indi-cators)capturethemonthlyabnormalreturnsoflitigatedfunds fromSeptember2002toSeptember2006.Fig.2plotsthe cumula-tiveabnormalreturnsoflitigatedfundsusingthecoefﬁcientsfor theinteractionterms.Thecumulativeabnormalreturnsare

rep-Fig.2.Comparisonofthecumulativeabnormalreturnsforlitigatedand non-litigatedfunds.

Werunpooledregressions(withfundandyear-monthﬁxedeffects)offundreturns usingthemarketmodel.TheobservationsarefromJanuary1999toDecember2007. Thedependentvariableisthemonthlyfundreturns(in%).Weusemonthly indi-catorstocapturealpha(abnormalreturnsineachmonth)forbothlitigatedand non-litigatedfunds.Wethenplotthecumulativeabnormalreturnsovera4-year periodaroundthelitigationfromSeptember2002toDecember2007forthelitigated fundsandthenon-litigatedfunds.

(10)

Table6

Crosssectionaldifferencesinfundflowsandreturns.Thistablesummarizestheresultsoftheindividualfund-levelestimatesfromtheflowmodelinPanelAandreturnmodel inPanelB.Inatwo-stepanalysis,wefirstruntimeseriesregressionsoftheflowsasinEquation(2)(seePanelA)andofthereturnsasinEquation(6)(seePanelB)foreach fund.Wecomparethesefund-levelestimatesacrossthefundgroupsclassifiedperSECchargehistory,whetherthefundisstand-aloneorpartofafinancialconglomerate, andwhethertheunderlyingassetsintheportfolioareliquid(usingthestyleclassification).PanelAandPanelBpresentthecrosssectionalmeansandt-statisticsofthe coefficientsonthepre-andpost-eventindicatorsfromtheindividualfundflowsandreturnsmodels,respectively.T-statisticsareinparentheses.*indicatessignificanceat 5%and**indicatessignificanceat1%.

Fullsample Chargehistory(Yes-No) Parentcompany (Stand-alone−conglomerate)

Portfolioliquidity (illiquid−liquid) PanelA−Fund-levelﬂowregressions

Pre-litigation,(−3,−1)months −0.31 −0.43 −0.16 −0.22

[−2.51]* [−1.44] [−0.48] [−0.86]

Post-litigation,(+1,3)months −1.25 0.84 −1.28 −0.49

[−10.74]** [2.84]** [−3.79]** [−2.08]*

PanelB−Fund-levelreturnregressionsusingCarhart4-factormodel

Pre-litigation,(−3,−1)months −0.06 0.13 0.23 −0.05

[−2.98]** [2.47]* [3.68]** [−1.27]

Post-litigation,(+1,3)months −0.12 −0.09 0.28 −0.02

[−5.69]** [−1.48] [4.23]** [−0.48]

Table7

Fundliquidityandflows.Thetablereportstheresultsofpooledfundflowregressions,whichincludelitigation-windowindicatorsinteractedwiththeilliquidityindicator. Weidentifyilliquidfundsusingthreeclassifications.ThefirstmeasureusesthefundstyleandidentifiesilliquidfundsasfundswithLipperobjectivecodes:CorporateBonds Low,DerivativeMortgages,GrowthorSmallorMidCapEquity,InternationalBonds,andInternationalEquity.Thesecondmeasureusesthecashholdingsasapercentageof theTNAandidentifiesilliquidfundsasfundswithcashholdingslessthanthesamplemedian.Thethirdliquiditymeasureusesthebid-askspreadofstockfundsheldintheir portfoliosandonlyincludesdomesticequityfunds.Illiquidfundsaredefinedasthosefundswhoseunderlyingportfolioweightedaveragebid-askspreadishigherthanthe samplemedian.

AllFunds AllFunds DomesticFunds

Fundstyleclassification Cashholdingclassification Bid-askspreadclassification

Pre-litigation[−3,−1] 0.19 0.41 0.04 [1.39] [2.51]* [0.16] Pre-litigation* −0.39 −0.52 −0.26 illiquidindicator [2.07]* [2.61]** [0.77] Litigationmonth[0] −0.47 −0.09 0.00 [3.35]** [0.58] [0.01] Litigationmonth* −0.21 −0.65 −1.11 illiquidindicator [1.06] [3.24]** [2.98]** Post-litigation[+3,+1] −0.84 −0.80 −1.11 [8.59]** [6.46]** [4.78]** Post-litigation* −0.55 −0.39 −0.77 illiquidindicator [3.43]** [2.56]* [2.34]* Illiquidindicator 0.63 −0.27 [1.83] [6.57]** Age −2.69 −2.63 −3.08 [30.10]** [13.92]** [15.97]** Size 1.12 1.54 1.18 [23.36]** [16.93]** [12.13]** Return 0.03 0.05 0.05 (1-monthlagged) [6.58]** [5.73]** [4.76]** CumulativeReturn 0.01 0.02 0.03 (3-months) [3.52]** [3.86]** [3.71]** CumulativeReturn 0.06 0.05 0.08 (6-months) [26.90]** [16.11]** [16.78]** ExpenseRatio 1.78 2.84 2.06 [8.00]** [8.22]** [5.28]** Managementfee −2.07 −3.33 −2.16 [9.30]** [9.76]** [4.72]** Industry-NormalizedFlow −0.98 0.59 −0.93 [10.87]** [2.11]* [3.92]** Style-NormalizedFlow 0.54 0.59 0.34 [22.40]** [14.89]** [4.56]** Constant −1.18 −2.65 −1.15 [2.66]** [3.58]** [1.37]

FundFixedEffects Yes Yes Yes

Year-MonthFixedEffects Yes Yes Yes

Observations 782,903 399,041 186,358

NumberofFunds 10,463 8763 2010

R2 _2.8% _1.8% _3.6%

resentedasthedollaramountover1USDthatishypothetically

invested.Fig.2showsthatpriortolitigationannouncements,there

isnoabnormalreturndifferencebetweenthetwogroupsoffunds. However,afterlitigationannouncements,non-litigatedfunds con-sistentlyperformbetterthanlitigatedfunds.

4.3. Cross-sectionaldifferencesinﬂowsandreturns

We conduct fund-by-fund estimationsof the cross-sectional differencesin fundrunsandreturns beforeand afterlitigation. Speciﬁcally,we add indicators tothe ﬂows and return models

(11)

Table8

Evidencefromthedailyfundreturns.Pooledregressions(withfundandyear-monthfixedeffects)ofdailyreturnsarerunusingthemarketmodel,theFama-French3-factor model,theCarhart4-factormodel,andmarketmodelswithlaggedreturnsandliquidityfactors(inclusiveoftheFFequations).Thepre-litigationindicatorindicates[−20, −1]daysbeforethelitigationannouncement,thepost-litigationindicatorindicates[1,20]daysafterthelitigationfiling.Theeventindicatorindicatesthedaysbetweenthe newsdateandthelitigationfilingdate.Thesamplecoversbothlitigatedandnon-litigatedfunds.Thenon-litigatedfundobservationscoverthemaximumofthelitigated funds’observationwindow.Thet-statisticsareinbracketsbelowthecoefficientestimates.*and**indicatethesignificancelevelatthe5%andthe1%levels,respectively.

Pooledregressionsoffundreturnsonpricingfactors,fundcharacteristicsandevent-windowindicators MarketReturns Fama-French FF+Liquidity

Factor

Carhart4-Factor+Liquidity Factor

All+Lagged MarketReturns

Pre-litigation(−20,−1)days −0.58 −1.44 −1.47 −1.36 −1.33

(2.33)* (5.90)** (6.00)** (5.56)** (5.45)**

Daysbetweenlitigation 0.07 −0.57 −0.63 −0.53 −0.49

newsandﬁling −0.28 (2.25)* (2.47)* (2.06)* (−1.93)*

Post-litigation(1,20)days −0.64 −1.37 −1.44 −1.34 −1.31 (2.54)* (5.49)** (5.76)** (5.36)** (5.21)** MarketReturn 0.17 0.14 0.18 0.18 0.15 (1067)** (1044)** (1042)** (1041)** (1041)** SMB 0.11 0.11 0.11 0.09 (422.16)** (421.68)** (420.88)** (419.49)** HML 0.09 0.09 0.09 0.09 (235.86)** (235.01)** (233.77)** (233.08)** LiquidFactor 0.02 0.02 0.02 (5.87)** (7.34)** (7.73)** Momentum 0.03 0.03 (9.80)** (9.20)**

LaggedMarketReturn −0.01

(3.54)** Size 0.57 0.49 0.48 0.48 0.49 (16.36)** (14.23)** (14.07)** (14.04)** (14.15)** Log(age) −0.83 −0.35 −0.42 −0.4 −0.4 (15.47)** (6.69)** (7.72)** (7.43)** (7.39)** ExpenseRatio 0.03 0.02 0.02 0.02 0.02 (17.49)** (12.35)** (12.49)** (12.70)** (12.81)** Constant −0.02 −0.02 −0.02 −0.02 −0.02 (8.68)** (9.01)** (8.35)** (8.63)** (8.76)**

FundFixedEffects Yes Yes Yes Yes Yes

DateFixedEffects Yes Yes Yes Yes Yes

#ofObservations 7,957,529 7,957,529 7,957,529 7957529 7,957,529

NumberofFunds 8934 8934 8934 8934 8934

R2 _13% _15% _15% _15% _15%

(Equations(2) to(7))forthethree monthsinthepre-litigation

andpost-litigationwindows.Table6summarizesthefund-level estimatesandcomparesthemacrossthesubsamplefundsperthe liquidityof theunderlying portfolio,SEC litigation history, and whetherthefundisastand-aloneorpartofaconglomerate.

PanelAofTable6reportsthecross-sectionalmeanofthe coef-ficientsforthree-monthpre-litigationandpost-litigationmonth indicatorsandthecorrespondingt-statisticsinthefullsampleand thesubsamples.Abnormalflowsinthethreemonthsbeforeand afterthelitigationaresignificantandnegativeinthefullsample, indicatingthat investors runfundsboth beforeand after litiga-tion.Furthermore,post-litigationrunsarelargerthanpre-litigation runs(−1.25percentvs.−0.31percent).Thepost-litigation abnor-maloutflowsofilliquidfunds(illiquidfundsinvestinsmall-cap stocks,internationalequityandbonds,andasset-backedsecurities) relativetoliquidfundsaresignificantlylarger.Theseresultsare consistentwithourhypothesisthatinvestorsinilliquidfunds,that aresusceptibletohighercostsuponredemption,aremorelikelyto runthelitigatedfunds.

PanelBofTable6reportsacomparisonofthecoefficient esti-matesonthethreemonthspre-andpost-eventindicatorsfromthe returnmodels.Thefirstcolumnpresentsthereturnbenefitsforall investigatedfunds,whereastheremainingcolumnslistthe aver-agereturndifferencesandthet-statisticsacrossfunds,subsampled accordingtotheliquidityoftheunderlyingportfolio,priortheSEC litigationhistory,andwhetherthefundisastand-aloneorpartof aconglomerate.Therisk-adjustedreturns(alphas,asmeasuredby thedifferenceinthecoefficientsofthe3-monthspre-event indi-catorsandthe3-monthspost-eventindicators)aresignificantly

higherinthepre-eventwindowthaninthepost-eventwindow, especiallyforfundsholdingilliquidassets.

We furtherinvestigatetheeffectof illiquidityonfundflows byrunningpooledregressions thatinclude event-window indi-catorsand theirinteractionwiththefundilliquidityindicators, controllingforthefundcharacteristics.Threeliquidity classifica-tionsareused.Thefirstclassificationmeasuresfundilliquidityper theLipperobjectivecode.Liquidfundsinvestinlarge-capstocks andtreasurybills,whereasilliquidfundsinvestinsmall-capstocks, internationalequity andbonds,andasset-backedsecurities.The secondmeasurereliesonthecashholdingstoclassifythefunds. Theproportionof cashin theportfolio ofilliquid(liquid)funds is below(above) thesample median.The third measure classi-fiesfundsasilliquid(liquid)ifthevalue-weightedaveragebid-ask spreadofthestocksintheportfolioisabove(below)thesample median.Thethirdmeasurerestrictsthesampleoffundsto domes-ticequityfundsduetotheavailabilityofdataonthebid-askspread. Table7showsthatpre-eventandevent-monthoutflowsoflitigated fundsaremorepronounced(andstatisticallysignificant)for illiq-uidfunds.Post-eventfundrunsaresalientforalllitigatedfundsbut evenmoresoforilliquidfunds.AppendixDpresentstheresultsof similarregressionswiththe13event-month indicators.Overall, theevidenceisconsistentwiththeconjecturethatpayoff comple-mentarityisstrongerforilliquidfunds.

Bothreputationandliquiditymayaffectfundrunsandreturn differences.Infact,agoodreputationmayalleviateinvestor sus-picionsofmismanagementandthusreduceruns,which inturn maydecreasetheprobabilityoffinancialcontagion.To disentan-gle motivationsrelated tofire-sale costs fromthose related to penalizingmanagement,werunflowregressionsinfunds,

(12)

subsam-Table9

Liquidityandcumulativeabnormalreturnsofstocksandownershipbyinvestigatedfunds.ThetablerunsregressionsofCARs(7-day,14-day,24-day,44-day,and64-day) andtherelativebid-askspreadon%ofsharesheldbylitigatedfunds,illiquidindicator,andaninteractiontermfortheilliquidindicatorandthepercentageofsharesheldby litigatedfunds.TheregressionscoverallCRSPstockswithbid-askandCARdataregardlessofwhetherornottheyareheldbylitigatedfunds.PanelA,BandCreportsthe regressionresultsforallmonths,forSeptember2003andOctober2003,respectively.*and**denotesigniﬁcanceatthe5%and1%level,respectively.

CAR CAR CAR CAR CAR Relativebid-ask

[−3,3] [−3,10] [−3,20] [−3,40] [−3,60]

PanelA:Alllitigationmonths

Heldbylitigatedfunds(%): 0.00 0.00 0.00 0.00 0.00 0.00

[0.22] [0.24] [0.17] [0.11] [0.02] [0.18]

Illiquidstockindicator −0.01** −0.01** −0.03** −0.05** −0.07** −0.01**

[17.22] [16.63] [28.09] [32.95] [40.04] [95.51] Interaction 0.12 −0.02 0.11 0.12 0.21 0.02 [1.93] [0.25] [0.90] [0.73] [0.98] [1.45] Constant 0.00 0.00** 0.00** 0.00 −0.00* −0.00** [1.31] [6.88] [4.57] [0.54] [2.35] [4.65] Observations 82,130 82,130 82,130 82,130 82,130 81,436 R2 _0.36% _0.34% _0.96% _1.31% _1.93% _10.14% PanelB:September2003

Heldbylitigatedfunds(%): −0.08 −0.02 0.08 −0.15 0.09 −0.03

[0.47] [0.09] [0.26] [0.33] [0.16] [0.70]

Illiquidstockindicator 0.02** 0.03** 0.00 0.00 −0.02** −0.01**

[11.15] [13.04] [1.20] [0.05] [4.48] [26.51] Interaction −0.01 −1.26* −1.39* −0.94 −0.11 0.16 [0.03] [2.23] [2.05] [0.95] [0.08] [1.83] Constant 0.00 0.00 0.01** 0.02** 0.04** −0.00* [1.01] [0.92] [3.20] [6.38] [9.40] [2.53] Observations 9775 9775 9775 9775 9775 9771 R2 _1.30% _1.75% _0.06% _0.02% _0.21% _6.78% PanelC:October2003

Heldbylitigatedfunds(%): 0.00 0.00 0.00 0.00 0.00 0.00

[0.03] [0.11] [0.12] [0.07] [0.01] [0.06]

Illiquidstockindicator −0.01** −0.01** −0.03** −0.07** −0.06** −0.01**

[5.03] [3.25] [12.53] [24.05] [16.37] [52.15] Interaction −0.08 −0.49* −0.58* −1.11** −1.23** 0.07* [0.59] [2.41] [2.19] [3.01] [2.79] [2.24] Constant 0.00** 0.01** 0.01** 0.03** 0.03** −0.00** [5.42] [10.21] [9.53] [11.93] [12.13] [4.79] Observations 19,476 19,476 19,476 19,476 19,476 19,464 R2 _0.14% _0.09% _0.86% _3.03% _1.46% _12.30%

pledaccordingtoliquidityandreputation.PanelAofAppendixE

runsfund-levelregressionsofflowsonfundcharacteristicsand13 monthindicatorsaroundthelitigationannouncementsinthe sub-samplesoffundsclassifiedaccordingtoliquidity(usingthestyle classification)and reputation. Thefoursubsamples are: noSEC chargehistoryandliquid;noSECchargehistoryandilliquid;SEC chargehistoryandliquid;SECchargehistoryandilliquid.Thelast fourcolumnsinAppendixEreportthet-testsfortheequalityofthe pre-eventwindowandthepost-eventwindowcoefficientsinthe foursubsamples.AppendixEshowsthatevenwhenwecontrolfor priorSECchargehistory,illiquidfundssufferfrommoreoutflows (around4percentmore)inthesixmonthsfollowingthelitigation news.

PanelBofAppendixErunsfund-levelregressionsofthenet returnsusingtheCarhart4-factormodeldepictedinEquation(6) through (7) and the 13 event-month indicators. The funds are subsampledintofourgroupsperliquidity(usingthestyle classi-ﬁcation)andreputation.Boththeilliquidityofthefundportfolio andapoorreputationhurtreturnsinthe6monthsfollowingthe litigationnews.Theeffectofilliquidityandapoorreputationseem alsotomatterinthe6monthsbeforethelitigationnewsbutthe statisticalsigniﬁcanceisnotasrobust.

4.4. Evidencefromthedailydataandtheholdingdata

Weusedailyreturndatatoinvestigatetheimpactoflitigation onfundreturns.Werunpooledregressionsusingtheﬁve

asset-pricingmodels,Equations(3)through(7).Theregressionscover bothlitigatedandnon-litigatedfunds.AsTable8shows,litigated fundssigniﬁcantlyunderperformnon-litigatedfundsinthethree eventwindows.Themagnitudeoftheunderperformanceisashigh as1.44basispointsdaily,whichisnearly25basispointsduringthe 20-daywindow.Ifthefundrunlastsmuchlongerthan20days,the totalunderperformancewillbelargerthan25basispoints.

Table9investigatestheliquidityandabnormalreturnsofstocks heldbylitigatedfunds.WerunregressionsoftheCARs(7-day, 14-day,24-day,44-day,and64-day)aroundthelitigationfilingsand therelativebid-askspreadon%ofsharesheldbylitigatedfunds,the illiquidindicator,andaninteractiontermfortheilliquidindicator andthepercentageofsharesheldbylitigatedfunds.The regres-sionincludesallCRSPstockswithbid-askandCARdataregardless ofwhetherornottheyareheldbylitigatedfunds.Thesixregression specificationsuseasindependentvariables7-day,14-day,24-day, 44-day,and64-dayCARsandtherelativebid-askspread, respec-tively.PanelAofTable10reportstheregressionresultsforallthe litigationfilingsandallthestocks:PanelBreportstheregression resultsforallthelitigationfilingsinSeptember2003;andPanelC reportstheregressionresultsforallthelitigationfilingsinOctober 2004.

Theresultsofthefullsample(inPanelA)indicatethatfunding illiquidityofmutualfundsdoesnotseemtoaffecttheabnormal returnsandtheliquidityofthestocksthattheyholdintheir port-folio.However,wecannotpreciselymeasureiforwhenamutual fundsellsthestockintheirportfolios.Furthermore,weshowthat

(13)

thefundingilliquidityofmutualfunds(largeoutflows)ismost pro-nouncedintheimmediateaftermathoflitigation.Assuch,wealso lookatthesubsampleresultsinthefirsttwomonthsoflitigation, SeptemberandOctober2003.Theinteractiontermbetweenilliquid stocksandtheproportionheldbylitigatedfundsshowsthatlarge outflowsoflitigatedmutualfundsresultinsignificantlylowerCARs inthe14-dayand24-daywindowsinSeptemberandlowerCARs inthe14-daythroughthe64-daywindowsinOctober.Theresults alsoindicatethattherelativebid-askspreadofilliquidstocksthat areheldbylitigatedfundsincreases,indicatingafurtherdecrease intheilliquidityofthealreadyilliquidstocks.13

5. Conclusion

Thispaperdocumentsmutual-fundruns.Wefindthatpre-event runsstartasearlyasthreemonthspriortoanannouncementof lit-igationandthesizeofthepre-eventrunissmallerthanthatofthe post-eventrun.Thetimingandsizeoftherunsarealsoaffected byfundandinvestorcharacteristics,suchasthereputationand liquidityoftheunderlyingassets.Furthermore,becauseconcerted runstriggerfiresalesthatresultinsignificantcosts,investorswho runfundspriortolitigationannouncementsrealizehigherreturns thanthosewhorunfundsafterlitigationannouncements, espe-ciallywhenthefundsareless-liquid.Evidencefromtheholding dataonperformanceandliquidityalsosupportstheproposition thatfire-salecostsareanimportantmotivationbehindfundruns. Theseresultssuggest thatthepro-rata distributionof proceeds fromassetsalesisnotsufficienttopreventfundruns.

13 _For_an_excellent_review_on_{interconnectivity}_of_markets_and_how_ﬁnancial

dis-tressspreadsbetweenmarkets,theinterestedreadermayrefertoSilvaetal.(2017).

Therationaleforexitingearlyhascriticalimplicationsfor sta-bilityinthefundindustry:oncethetimingofanactionmattersfor thepayoff,strategiccomplementaritiesprevail.Insuchasituation, investorsmayrunfundsintheexpectationthatotherinvestors willdosoaswell,whichwillamplifytheimpactofadverseevents orrandomshocksonfinancialmarketfundamentals.Nonetheless, becausedepressedpricesduringfiresalesmaysoonberecovered aslongastheliquidityshockdoesnotembraceallsectors,the self-fulfillingmechanismandthedevastatingconsequencesofabank runarenotlikelytobemanifestedinthefundindustry.Rather, fundrunscausedbyfundmispricingwillceasewhenthepriceis resetatafairvalue,andfundrunscausedbymismanagementwill ceasewhenthereputationofmanagementisrestoredora new clientprofileequilibriumisreached.

AppendixA.

TableshowstheaveragemonthlyflowsfromSeptember2002to September2004forthreegroupsoffunds:investigatedfundsprior tothelitigationmonth,investigatedfundsduringorafterthe litiga-tionmonth,andfundsinfamilieswithnoinvestigatedfunds.Funds infamilieswithnoinvestigatedfundsareusedasbenchmarksto testfortheflowdifferencesagainsttheinvestigatedfunds.PanelA usesallfunds,andtheeventmonthisidentifiedusing:thelitigation filingdate(firstspecification)andthefirstdatewhennewspaper articlesaboutlitigationappeared(secondspecification).PanelB groups thefundspertheirprior SECchargehistory and identi-fiestheeventmonthusingthelitigationnewsdate.T-statisticsare inbrackets.**and*denotesignificanceatthe1%and5%levels, respectively.

PanelA:Fullsample

ControlGroup TreatmentGroup(usinglitigationﬁlingdate) TreatmentGroup(usingnewspaperdate)

Date FundsinFamilies

withno Investigated Funds

1:Investigated FundsPriortothe LitigationMonth t(Diff) 2:Investigated FundsonorAfter theLitigation Month t(Diff) 1:Investigated FundsPriortothe NewspaperDate t(Diff) 2:Investigated FundsonorAfter theNewspaper Date t(Diff) Sep-02 0.38 1.02 [2.00]* . . 1.02 [2.00]* . . Oct-02 0.58 0.39 [−0.65] . . 0.39 [−0.65] . . Nov-02 0.71 1.28 [1.81] . . 1.28 [1.81] . . Dec-02 0.16 0.31 [0.49] . . 0.31 [0.49] . . Jan-03 0.96 0.53 [−1.52] . . 0.53 [−1.52] . . Feb-03 0.37 0.72 [1.99]* . . 0.72 [1.99]* . . Mar-03 0.91 0.71 [−0.61] . . 0.71 [−0.61] . . Apr-03 1.30 1.46 [0.51] . . 1.46 [0.51] . . May-03 0.94 1.14 [0.72] . . 1.14 [0.72] . . Jun-03 1.05 1.07 [0.07] . . 1.07 [0.07] . . Jul-03 0.86 0.63 [−0.72] . . 0.63 [−0.72] . . Aug-03 0.89 0.03 [−3.07]** . . 0.03 [−3.07]** . . Sep-03 0.71 −0.08 [−3.16]** −0.97 [−3.19]** 0.12 [−1.97]* −0.57 [−4.00]** Oct-03 1.31 1.22 [−0.19] −0.80 [−4.56]** 2.07 [1.15] −0.28 [−4.48]** Nov-03 0.95 0.73 [−0.84] −2.64 [−12.15]** 2.59 [2.66]** −1.12 [−9.80]** Dec-03 1.11 0.40 [−1.65] −2.02 [−7.66]** 2.19 [1.15] −1.19 [−7.32]** Jan-04 1.75 0.77 [−2.21]* −0.72 [−6.14]** 2.62 [0.95] −0.39 [−6.61]** Feb-04 1.32 0.59 [−1.28] −0.56 [−7.22]** 2.40 [1.03] −0.51 [−7.50]** Mar-04 1.01 0.34 [−0.64] −0.64 [−4.40]** . . −0.53 [−4.35]** Apr-04 0.72 −0.34 [−1.57] −0.71 [−5.54]** . . −0.67 [−5.70]** May-04 0.10 −1.46 [−2.39]* −1.52 [−6.74]** . . −1.52 [−7.12]** Jun-04 0.72 −0.61 [−1.50] −1.17 [−5.90]** . . −1.11 [−6.04]** Jul-04 0.72 −0.69 [−1.52] −0.93 [−4.96]** . . −0.90 [−5.18]** Aug-04 0.43 −0.09 [−0.16] −0.58 [−3.67]** . . −0.57 [−3.67]** Sep-04 0.37 1.49 [0.48] −0.83 [−6.22]** . . −0.82 [−6.16]** Oct-04 0.39 1.72 [0.54] −0.80 [−5.84]** . . −0.78 [−5.78]** Nov-04 0.85 . . −0.59 [−5.89]** . . −0.59 [−5.89]** Dec-04 0.19 . . −0.89 [−4.45]** . . −0.89 [−4.45]**