Essentially, what happens is that a whole bunch of money pours into the fund on a day when it's underpriced. This immediately dilutes the holdings of the long-term shareholders since the fund creates more shares for the new investors. Then, on a day when the fund is overpriced, all that money comes out. This squeezes ongoing shareholders because more of the fund's holdings must be liquidated to fund the withdrawals.
A super-simplified example can help make this dynamic clear. The following hypothetical case was developed by Peter Ciampi, principal architect of FT Interactive Data's Fair Value Information Service, which provides updated pricing information to mutual-fund companies. Ciampi uses this example to explain to fund company boards just how current shareholders, as well as the fund's returns, are being hurt by arbitrage traders.
EXHIBIT A. Consider a fund that has only one shareholder, one share of a Japanese stock, and $10 in cash. The stock last traded for $100 at 2 a.m. Eastern Time (when Tokyo's exchange closes). That makes the fund's net asset value (NAV) -- the total assets divided by the number of shares -- $110. Now let's say the U.S. market rises during the day. At 4 p.m., an arbitrageur comes in and buys one share of the hypothetical fund for $110. Now the fund has one share of stock, $10 cash, and $110 in cash from the arbitrageur.
When the Tokyo exchange opens at 7 p.m. (ET), the stock of the Japan-based company immediately rises from $100 to $110. The fund manager buys another share of the stock (investing the arbitrageur's $110 in cash) so the fund has two shares, $10 in cash, and a NAV of $115. If the arbitrageur hadn't come into the fund the day before, the original shareholder's stake, and the fund's NAV, would have been $120 at this point. "That shows how the wealth transfer is occurring," says Ciampi.
Now consider how the original shareholder could theoretically be wiped out when the arbitrageur withdraws his money. Let's say the U.S. market collapses the next day, and the arbitrageur sells at 4 p.m., getting out at a $115 price (and a one-day gain of 4.5%). When Tokyo starts trading at 7 p.m. (ET), the stock collapses, falling from $110 to $50. The fund manager then has to sell both the fund's shares, netting only $100 to pay back the arbitrageur. With just $10 in cash, the fund is wiped out, and the buy-and-hold shareholder has zero. Under that dire scenario, "if the arb hadn't liquidated the fund, at least the shareholder would have had $60," says Ciampi.
Bottom line, according to Jason Greene, associate professor of finance at the Robinson College of Business at Georgia State University: "The gains that these active traders make all come at the expense of the passive shareholders." By Amey Stone