Blurred stars: Mutual fund ratings in the shadow of conflicts of interest

Using unique data on trading commission payments to mutual fund rating companies (MFRCs) by mutual funds in China, this paper investigates whether the conflicts of interest arising from trading commission payments bias MFRCs’ mutual fund star ratings and hence affect their informativeness. We find the rating of a mutual fund is more optimistic when the MFRC either (i) receives trading commission fees from the mutual fund or (ii) can potentially receive fees in the future. The paper further shows that the usefulness of ratings in terms of predicting a fund’s future performance is negatively impacted by conflicts of interest. There is also evidence that investors can see through the problem, responding less enthusiastically (in terms of fund flows) to the ratings of conflicted MFRCs. We further find that the introduction of a rating qualification system that aims to improve mutual fund rating quality exacerbates the rating bias.     

Derivative use,fund flows and investment manager performance

Prior literature which examines the use of derivatives by investment managers does not discern between different types of derivative trading strategies. This study is the first to examine and gather data on a particular type of derivative trading strategy undertaken by investment managers. We examine the extent to which equity fund managers use index futures to manage fund flows and the effect this has on their alpha and market timing measures of performance. Our results show that funds that do not use derivatives exhibit lower returns and negative market timing skills when they experience fund flow. The performance of funds that use derivatives, however, is independent of investor’s liquidity demands. In fact, the unconditional performance of the average user fund is statistically equivalent to the performance of the average non-user fund conditional on zero fund flow. Our results provide evidence that derivatives can be beneficial for mutual fund holders under certain conditions.     

隐性杠杆约束、流动性风险和投资者情绪

本文以2003—2019年间开放式主动管理型的股票型和偏股型基金为样本,以持仓占比为权重估算基金投组中A股的总市场风险暴露,检验结果表明,该序列上升反映了基金面临的隐性杠杆约束收紧,刻画了市场的弱流动性。内在逻辑在于,流动性收紧时,投资者难以通过融资直接增加杠杆,更倾向于重仓持有高市场风险头寸的股票而间接实现杠杆。本文发现隐性杠杆约束所刻画的风险在股票或基金收益截面上的无条件定价基本失效,而条件定价则依赖于低市场情绪与弱流动性。分解基金持股的敞口,进一步发现,因中小盘基金在流动性收紧时具有更强的流动性偏好,其持股的市场风险头寸能够更敏锐地捕捉到弱流动性风险。     

The relationship between mutual fund fees and expenses and their effects on performance

Fees charged by mutual funds include front-end load charges, deferred sales charges that decrease over time, redemption fees that are imposed whenever shares are sold, and 12b-1 fees. Fees may be justified if they allow the fund to lower other costs or improve performance. In this paper, we find that, on average, 12b-1 fees, deferred sales charges, and redemption fees increase expenses whereas funds with front-end loads generally have lower expenses. We also find that funds with 12b-1 fees and redemption fees, on average, earn higher risk adjusted returns but funds with front-end load charges earn lower risk adjusted returns.     

Selling winners, holding losers: Effect on fund flows and survival of disposition-prone mutual funds

Recent studies suggest that presence of a disposition effect in a large subset of investors can create stock mispricings, which has serious implications for market efficiency. We examine whether US equity mutual funds are disposition-prone, how that effect influences performance, investor flows and fund survival, and whether the disposition orientation of mutual funds affects stock prices in a sustained manner.We find that about 30% of all funds exhibit some degree of disposition behavior and that such funds underperform funds that are not disposition-prone by 4-6% per year. Moreover, after controlling for performance, tax overhang and other factors that potentially affect flows, disposition-prone funds attract significantly smaller flows than other funds. The results suggest that mutual fund investors are smart enough to minimize investment in disposition-prone funds. Consequently, disposition-prone funds have significantly higher rates of failure than other funds, thereby reducing the impact of such trading behavior on security prices.     

Credit ETFs in Mutual Funds and Corporate Bond Liquidity

We show that high yield (HY) mutual funds own and trade ETFs to manage liquidity needs driven by fund flows, whereas investment grade (IG) funds do not. The use of ETFs by HY mutual funds to manage liquidity shifts some trading away from bonds and into ETFs, which reduces the liquidity of the underlying bonds. This substitution effect outweighs the better-understood inclusion effect, whereby bond liquidity benefits from increased ETF ownership, such that the net effect of ETFs is to reduce HY liquidity. In IG, the substitution effect is not significant and ETFs result in increased bond liquidity.     

UNITARY BOARDS AND MUTUAL FUND GOVERNANCE

A unique governance structure for mutual funds is unitary board—one board overseeing all funds in the entire family. We find strong evidence for unitary board as an effective governance mechanism. Funds with unitary boards are associated with lower fees, are more likely to pass the economies of scale benefits to investors, are less likely to be involved in trading scandals, and rank higher on stewardship. In contrast, funds with larger or more independent boards charge higher fees and rank lower on stewardship. Our findings indicate that unitary boards of small size, rather than independent boards, may be more beneficial to fund shareholders.     

Decomposing the persistence of international equity flows

The portfolio flows of institutional investors are widely known to be persistent. What is less well-known, however, is the source of this persistence. One possibility is the ‘informed trading hypothesis:’ that persistence arises from autocorrelated trades of individual investors who believe they have information about value and who face an imperfectly liquid market. Another possibility is that there are asynchroneities with respect to investment decisions across funds, across investments, or both. These asynchroneities could be due to wealth effects (across investments for a single fund), investor herding (across funds for a single investment), or generalized contagion (across funds and across investments). We use daily data on institutional flows into 21 developed countries by 471 funds to measure and decompose aggregate flow persistence. We find that the informed trading hypothesis explains about 75% of total persistence, and that the remaining amount is attributable entirely to cross-fund own-country persistence. While asynchroneities across funds investing in the same country are important, asynchroneities across countries, either within a given fund, or across funds, are not important. The cross-fund flow lags we identify might result from different fund investment processes, or from some funds mimicking others' decisions. We reject the hypothesis that wealth effects explain persistence.     

The Only Fund in Town? Geographic Segmentation in the US Mutual Fund Industry

We find that mutual funds located in regions with more competing funds charge lower management fees, but higher fees related to sales and distribution (12b‐1 fees), sales loads, and other nonmanagement fee expenses. There is some evidence that funds in more competitive regions have higher total expense ratios than similar funds in less competitive regions. Our results indicate that while increased competition drives down fund profits, it creates a negative externality by way of increased sales expenses. Overall, our results suggest the mutual fund industry is characterized by monopolistic competition determined at the local level.     

Independent Directors and Favoritism: When Multiple Board Affiliations Prevail in Mutual Fund Families

I examine whether independent directors with multiple board affiliations (IDMAs) trade off the interests of one fund relative to another (fund favoritism) or whether they benefit fund shareholders by increasing the level of the board's expertise. Using a sample of mutual funds affiliated with the top 55 fund sponsors from 2002 to 2008, I find that the presence of IDMAs is negatively related to performance/resource shifting across funds within fund families. IDMAs appear to decrease fund fees, increase the return gap associated with the unobserved actions of fund managers, and facilitate the transfer of information across funds in a fund family.     

The cross-section of mutual fund fee dispersion

In this paper, we empirically analyze the factors affecting the cross section of mutual fund fee dispersion. In the context of equity mutual funds, fee dispersion stems primarily from the heterogeneity of products, clienteles and production functions. However, the relevant theory predicts that search costs can also generate fee dispersion. By controlling for observable sources of heterogeneity, we find that fee dispersion decreases with fund size and age, as well as with the amount of assets under management of the investment company. In addition, we find lower levels of fee dispersion for funds that charge marketing and distribution fees. Although we cannot rule out the possibility that these factors are a proxy for some unobserved source of heterogeneity, our results are also consistent with the theoretical prediction that search costs positively affect fee dispersion.     

Small-cap equity mutual fund managers as liquidity providers

This paper examines the relation between the performance of small-cap equity mutual funds and the liquidity characteristics of their asset holdings. We study the trading behavior of fund managers and show that on average, they tend to buy less liquid stocks and sell more liquid stocks. We introduce the notion of net “liquidity creation” by fund managers and examine its role in explaining the cross section of small-cap equity mutual fund returns. Our empirical results show that on average, small-cap mutual fund managers are able to earn an additional 1.5% return per year as compensation for providing such liquidity services to the market.     

Agency costs,governance, and organizational forms: Evidence from the mutual fund industry

Using a comprehensive sample of mutual funds and fund families for the period 1992–2004, this study examines the impact of fund management companies’ organizational forms on the level of agency costs within mutual funds. We find that, all else being equal: (1) funds managed by public fund families charge higher fees than those managed by private fund families; (2) public fund families acquire more funds than private fund families; and (3) funds of public fund families significantly underperform funds of private fund families. Collectively, these findings suggest that agency costs are higher in mutual funds managed by public fund families. Our results are consistent with the idea that the agency conflict between the fund management company and fund shareholders is more acute for public management companies because of their shorter-term focus.     

MUTUAL FUND TRADES: ASYMMETRIC LIQUIDITY PREFERENCES AND FUND PERFORMANCE

We investigate the role of the liquidity of stocks traded by mutual funds on the performance of funds experiencing substantial and sustained redemptions (outflows) or inflows. Accordingly, we identify 770 redeeming fund‐periods and 1,757 inflow fund‐periods and find a statistically significant relation between the liquidity of the stocks they trade and the quantity of the stock traded. Notably, when funds experience redemptions, those with low portfolio liquidity have an elevated preference for selling more‐liquid stocks. In the following period, such funds statistically and economically underperform funds that sell less‐liquid stocks. This is consistent with redemptions detrimentally affecting shareholders that remain in a fund.     

AGENCY CONFLICTS IN DELEGATED PORTFOLIO MANAGEMENT: EVIDENCE FROM NAMESAKE MUTUAL FUNDS

Namesake funds provide a unique sample for studying the two agency conflicts that exist within a mutual fund. The first is between the fund management company and fund shareholders, and the second is between the fund management company and the fund manager. A typical namesake fund manager sits on his or her fund's board, frequently as the chairman, is the majority owner of the fund management company, and has significant investments in the fund he or she manages. Our results indicate that namesake funds charge higher fees, suggesting that the boards of namesake funds are less effective. We find that namesake funds are more tax efficient, consistent with the idea that managerial ownership helps align the interests of managers with those of shareholders. Because of fewer career concerns, namesake fund managers herd less while assuming greater unsystematic risk. We find weak evidence that namesake fund managers outperform their benchmarks and peers. Finally, we observe that namesake funds attract higher levels of investor cash flow.     

Mandatory Portfolio Disclosure,Stock Liquidity,and Mutual Fund Performance

We examine the impact of mandatory portfolio disclosure by mutual funds on stock liquidity and fund performance. We develop a model of informed trading with disclosure and test its predictions using the May 2004 SEC regulation requiring more frequent disclosure. Stocks with higher fund ownership, especially those held by more informed funds or subject to greater information asymmetry, experience larger increases in liquidity after the regulation change. More informed funds, especially those holding stocks with greater information asymmetry, experience greater performance deterioration after the regulation change. Overall, mandatory disclosure improves stock liquidity but imposes costs on informed investors.     

Liquidity supply in electronic markets

We examine the supply of liquidity by proprietary trading desks and hedge funds (PTDH) versus mutual funds, index funds, and insurance companies (MII) across ten bid (ask) steps of the limit order book. We document that institutional investors simultaneously supply liquidity at multiple prices in the limit order book. We also find that PTDHs are more price aggressive liquidity suppliers than MIIs, consistent with hypothesized responses to observed changes in the cost and risk of non-execution. We investigate whether these findings are robust to fast versus slow markets, the volatility of daily returns, and aggregate depth relative to daily volume.     

Flight-to-liquidity,market uncertainty,and the actions of mutual fund investors

We explore the trading decisions of equity mutual funds during ten periods of extreme market uncertainty. We find that mutual funds reduced their aggregate holdings of illiquid stocks. Exploring the drivers behind this result reveals that this is mainly driven by larger withdrawals from funds that hold less liquid stocks. We further find that the sell-off of illiquid stocks occurred only after initial deterioration in market conditions, consistent with retail investors’ response to bad performance. At a broader level, this shows that mutual funds consumed liquidity during periods where liquidity was most valuable. Moreover, the fact that fund managers traded in response to these withdrawals suggests a potentially magnifying channel for the drop in illiquid stock prices, also known as flight-to-liquidity.     

Who Charges More: Hedge Funds or Mutual Funds?*

Explicit mutual fund fees are typically less than 1% of the assets under management. By comparison, the typical hedge fund charges a base fee of 2% plus a performance fee equal to 20% of net profits. Thus, hedge funds appear to charge far more for even comparable performance—unless one takes account of the following:

• ? For most mutual funds, a very high percentage of performance is driven by its passive exposure to the market, even though the fee is applied to the total fund.
• ? Many hedge funds are designed to provide returns that are completely independent of market performance.

Using these two assumptions, the author provides a simple example that shows that a representative mutual fund's performance can be replicated by combining an index fund, which represents the mutual fund's passive component, with a hedge fund, representing the mutual fund's active component. When analyzed in this way, the fee of the combined fund turns out to be remarkably close to the actual fee of the mutual fund. This in turn suggests that the implicit fee for the mutual fund's small active component is comparable to the fees of the hedge fund.     

Are mutual funds sitting ducks?

We find that patient traders profit from the predictable, flow-induced trades of mutual funds. In anticipation of a 1%-of-volume change in mutual fund flows into a stock next quarter, the institutions in the same 13F category as hedge funds trade 0.29–0.45% of volume in the current quarter. A third of the trading is associated with the subset of 504 identified hedge funds. The effect is stronger when quarterly mutual fund portfolio disclosure is required and among hedge funds with more patient capital. A one standard deviation higher measure of anticipatory trading by a hedge fund is associated with a 0.9% higher annualized four-factor alpha. A one standard deviation higher measure of anticipation of a mutual fund's trades by institutions is associated with a 0.07–0.15% lower annualized four-factor alpha. The effect is stronger for more constrained mutual funds.