Mutual fund families routinely, and on purpose, use the capital in affiliated funds as “insurance pools” to offset or prevent cash shortfalls in other funds within family, according to research released by the Kelley School of Business at Indiana University.
This practice sacrifices the performance of the affiliated fund of the mutual fund, or AFoMF. However, according to the research, it is not outlined in prospectuses and may be in direct conflict with the shareholder interest of these funds.
"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," stated 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."
Bhattacharya said that current laws allow affiliated funds to sidestep regulations that severely constrain cross-dealings among mutual funds in one family. Yet, he argued that the law does not allow them to sacrifice their own shareholders' interests for the benefit of the family. Moreover, he said that 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 affiliated fund investors.
Mutual fund families, he said, like conglomerates, have complex 'internal capital markets' that allocate resources during rough patches. Like conglomerates, fund families face tradeoffs between the interests of individual units and those of the parent company.
But, Bhattacharya stated that “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 affiliated funds 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.
"Our analysis leaves no doubt that fund families are playing fast and loose with AFoMF resources," said Bhattacharya. "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."
The report’s co-authors include Jung Hoon Lee and Veronika Krepley Pool, who are also faculty at the Indiana University Kelley School of Business. The study is forthcoming in the Journal of Finance.
Tommy Fernandez writes for Money Management Executive.