In the past, some mutual funds often engaged in a practice called “after-hours trading” that allowed some of their larger shareholders to reap profits or avoid losses in a manner not available to all investors. To understand how this practice works, one must remember that mutual fund prices (NAVs) are based on the underlying prices of the securities in which they are invested. Mutual fund prices are established each day at 4 p.m. Eastern Time, when the market closes. For this reason, mutual fund orders to buy or sell must be placed by investors prior to 4 p.m. The afterhours trading practice allowed certain large investors the opportunity to place and execute mutual fund trades after 4 p.m. Thus, if a news release occurred at 5 p.m. that would have a detrimental effect on the stock of a company held by a mutual fund, a large investor could sell the mutual fund shares based on a price prior to the announcement and therefore avoid a potential loss.
a. Discuss the ethics of this practice.
b. If you knew about this practice, would it have stopped you from investing in mutual funds? Discuss.