Last modified: Thursday, March 29, 2012
Study: Mutual fund families deliberately sacrifice performance of some funds to shore up losses elsewhere
Shareholders in dark about common practice that may directly conflict with their best interests
FOR IMMEDIATE RELEASE
March 29, 2012
BLOOMINGTON, Ind. -- Mutual fund families routinely and purposely use the capital in affiliated funds of mutual funds -- AFoMFs -- as "insurance pools" to offset or prevent cash shortfalls in other funds in the family. Further, this practice, which sacrifices performance by the AFoMF for the benefit of the fund company, is not outlined in prospectuses and may be in direct conflict with AFoMF shareholder interest.
These are the major findings of first-of-its-kind research from the Indiana University Kelley School of Business.
"From the fund families' point of view, this approach is perfectly rational because, as we document, the overall benefits to the company exceed the cost to the individual AFoMF," said Utpal Bhattacharya, associate professor of finance at the Kelley School and co-author of the study. "That said, AFoMF investors who have acted in good faith are left holding the bag."
The law allows AFoMFs to sidestep regulations that severely constrain cross-dealings among mutual funds in one family, but the law does not allow them to sacrifice their own shareholders' interests for the benefit of the family. According to Bhattacharya, the study's findings do signal potential ethics and legal questions, including whether fund families engaging in this practice have breached their fiduciary duties to AFoMF investor
"Mutual fund families, like conglomerates, have complex 'internal capital markets' that allocate resources during rough patches," Bhattacharya said. "Like conglomerates, fund families face tradeoffs between the interests of individual units and those of the parent company. But conglomerates do not have a fiduciary responsibility to the individual units, but fund families do. We set out to understand how internal capital markets operate in mutual fund families, and most important, whether they conflict with shareholder objectives."
The researchers drew on data from Morningstar Principia spanning October 2002 to January 2008 to identify AFoMFs and their holdings. The data was then hand-matched to the CRSP mutual funds database and subjected to a number of analyses that revealed that distressed non-AFoMF funds -- those experiencing the largest withdrawals from their outside investors -- saw a statistically significantly higher average liquidity flow from its family AFoMF than from any of the other mutual funds in the complex.
Additional tests demonstrated that AFoMFs:
- Provide liquidity to funds in the family experiencing temporary and severe liquidity shortfalls that can be partly explained by asset allocation (the "favorite" alternate explanation given by the industry), but not wholly.
- Do this even when the AFoMFs are cash poor, and even did this during the 2008-09 crisis.
- Do not do this if liquidity shortfalls in the underlying fund are persistent (so they distinguish between poor skill and poor luck).
- Do this more if the underlying fund is less liquid.
- Do this more if funds similar to the distressed funds are also selling.
- Are very different from Unaffiliated Funds of Mutual Funds (funds of funds that have to invest outside the family), in that the latter do not provide such liquidity.
"Our analysis leaves no doubt that fund families are playing fast and loose with AFoMF resources," Bhattacharya said. "What is especially baffling is why fund managers, whose careers ordinarily rest on investment performance of their own fund, would make this sacrifice to benefit the fund family? This matter should be a top priority for the mutual fund industry and regulators."
Bhattacharya speculates that the AFoMF managers are instructed to "take one for the team," or that their compensation or career prospects are designed so that rewards partially reflect the fund family's total performance. He also thinks it's possible that mutual fund managers within a family have an implicit understanding in which they might share information to boost AFoMF performance knowing that if their funds are in trouble, AFoMF managers will come to their aid.
Bhattacharya's co-authors include Jung Hoon Lee and Veronika Krepely Pool, who are also faculty at the Indiana University Kelley School of Business. The study, "Conflicting Family Values in Mutual Fund Families," is forthcoming in the Journal of Finance.