Litigations And Mutual Fund Runs
Australian National University (ANU) – College of Business and Economics
This paper investigates whether anticipation of adverse events (litigations over market-timing and late-trading) can trigger runs in mutual funds. We find that runs start as early as four months before litigation announcements. The pre-event runs over a six-month window accumulate to 4.95% of total net assets and post-event runs last over two years and accumulate to 7.94% for the first six months window. Additionally, investors who run before litigation announcements earn significantly higher risk- and peer-adjusted returns, as high as 1.16% more than those who run after. The difference in returns is particularly high for funds holding illiquid assets. Our analysis suggests that a pro-rata ownership design does not suffice to prevent runs in mutual funds.
Litigations And Mutual Fund Runs – Introduction
The first-come-first-served principle governing deposit withdrawals at par motivates bank runs: depositors want to withdraw before others do because those at the back of the line may not recover their deposits (Diamond and Dybvig, 1983; Chari and Jagannathan, 1988; Zhu, 2005; Chen and Hasan, 2006, 2008; Dwyer and Samartin, 2009). In contrast, mutual funds allocate the proceeds from asset sales on a pro-rata basis, a design that should shield them from runs. However, mutual funds may prove susceptible to runs on revelation of adverse information about the quality of management or underlying assets, even though a physical queue of withdrawers, as in bank runs, is absent. This paper provides direct evidence of mutual-fund runs both before and after the revelation of an adverse event and the motivation for why these runs may take place.
We define a fund run as an abnormally concerted redemption of mutual fund shares in anticipation or revelation of an adverse event. The adverse events we focus on are the 2003 and 2004 litigations alleging that certain mutual funds allowed some investors to engage in late trading and market timing,1 thereby allowing the preferentially treated investors to enjoy profits at the expense of investors who did not engage in these practices. Upon the suspicion or revelation that fund managers do not serve the interests of all investors equally, disadvantaged investors may discipline the implicated funds by withdrawing existing investments and/or by withholding new investments.
We first document pre- and post- event runs around litigation announcements. To investigate the motivation for runs, we focus on the benefits of redeeming shares before the adverse information becomes public, i.e., the pre-event runs. Concerted redemption and the lack of new sales that follow litigation announcements force funds to liquidate assets quickly, and the large volume of trading may temporarily depress underlying asset prices. Because shareholders who redeem shares at this time will suffer losses, investors who can anticipate litigations and the subsequent redemptions have incentives to redeem shares early. By exiting early, informed investors avoid the fire-sale costs caused by subsequent concerted withdrawals. Furthermore, the incentive for early runs will be greater for funds whose return differences from withdrawal timing are larger either because they hold illiquid assets or because they are likely to suffer larger outflows.
Our paper supports the above arguments by empirically answering three questions: First, do runs occur both before (pre-event) and after (post-event) litigation announcements? Second, do investors who run prior to announcements avoid costs that investors who run post suffer from? Finally, is the return difference larger for funds with illiquid assets or large outflows? First, we find that fund runs occur both prior to and post litigation announcements. Pre-event runs start as early as four months before litigation announcements. In the four months prior to litigations, monthly abnormal outflows from implicated funds range from .25% to .94% of total net assets (TNA). The abnormal outflows from implicated funds range from 1.03% to 2.03% of TNA in the six months following litigations. Not all funds prove equal in their vulnerability to runs. Funds holding illiquid assets experience more severe runs both prior to and post litigation announcements. Second, investors who run before litigation announcements earn significantly higher risk- and peer-adjusted returns (as large as 1.16%) than those who run after. This difference in returns is more pronounced in funds holding illiquid assets.
Our results indicate that mutual fund investors who anticipate negative flows motivated by litigations have incentives to withdraw early and avoid fire-sale costs. When the timing of the action (runs) matters for payoff (returns), strategic complementarities come into play that can amplify the impact of adverse events on fundamentals and generate financial fragility. Nonetheless, mutual fund runs may not occur unless there is a systematic liquidity shock to all fund investors (Chen, et al. 2010). In the absence of such a shock, other investors will purchase the assets at fire-sale prices and may thus correct the mispricing (Chen, et. al. 2008).
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