Mutual fund families: This article focuses on a paper done by Utpal Bhattacharya and Veronika Krepely Pool, featured on the Harvard Law Schools’ Blog Corporate Governance and Financial Regulation section.
At the 2021 SALT New York conference, which was held earlier this week, one of the panels on the main stage discussed the best macro shifts coming out of the pandemic and investing in value amid distress. The panel featured: Todd Lemkin, the chief investment officer of Canyon Partners; Peter Wallach, the managing director and Read More
It is often said that the provision of internal capital markets is a prime reason people form conglomerates or business groups. The internal capital markets promote the efficiency of the group by offering insurance pools, which provide liquidity at times when one of the parties of the group is hit by an adverse shock.
The concept of Mutual fund families takes the same form as business groups, but the biggest question mark rests on the ability to offer an insurance pool to the member mutual fund families. The conflict of interest arises between the shareholders and the mutual fund families whereby; a mutual fund owes a fiduciary duty only to its shareholders and never to the fund families. However. many claim that the interest of the group comes before the fiduciary duty, in some cases.
The interest of shareholders
The basic idea is to maximize shareholders’ funds, which means avoiding losses. This would include overlooking the challenges faced by the individual family funds, to concentrate on the overall return. This is a classical application of the hedging concept, which does not focus on the future of the mutual fund, but solely on the returns at the end of the year.
There have been claims that this is a legal requirement, but studies prove that more and more mutual funds have adopted the concept of business groups in its entirety.
The Interest of mutual fund
The idea here is to promote the overall efficiency of the fund by ensuring all the family funds are positively engaged towards a long-term common goal. In this case, the mutual fund seeks to help any struggling family member, by offering an insurance pool, which in turn provides liquidity to a fund that is hit with large losses.
This concept is borrowed from conglomerates or business groups, and has been applied by a big fraction of mutual funds, as noted by the writers, who conducted an empirical study on the subject.
The writers note the following findings from their study:
- 27 out of the 30 sampled mutual funds, had Affiliated Funds of Mutual Funds (AFoMFs), which means, they offer insurance pools among other business group features.
- Each family fund is sorted into deciles based on fund flows from its outside investors. The lowest decile (i.e., the group of distressed funds/funds experiencing the largest withdrawals from their outside investors) has a statistically significantly higher average inflow from its family AFoMFs than any of the other nine deciles. This usually occurs when a distressed family member receives support from the parent/holding fund. Mone of the mutual funds with AFoMFs admit the existence of insurance pools for liquidity provision in their manifestos.
- AFoMFs do not provide liquidity support to families that are money market funds, ETFs, or Treasury Funds. These are families that rarely need liquidity support, and hence the AFoMF should not make a provision for such funds.
- AFoMFs do not offer liquidity support to persistently distressed funds, but rather to those that face transient liquidity shortfalls. Additionally, AFoMFs provide liquidity support to a distressed fund of the mutual fund, even when they, themselves are cash strapped; this means that funds help whether or not the AFoMFs are liquid themselves.
- Unassociated Funds of Mutual Funds do not receive any liquidity support from the AFoMF. These are mutual funds that are outside the AFoMFs.
According to the above findings, the general view is that AFoMFs provide temporary liquidity to associated funds, a reason that could explain the exclusion of such a clause in the objectives of the AFoMFs sampled.
Using a temporary provision of liquidity support is further exhibited below.
Fire sale costs are higher for less liquid funds than for more liquid funds; the temporary liquidity provision should be higher for less liquid funds. AFoMFs provide greater insurance to less liquid and distressed funds than to more liquid U.S. equity funds.
If most funds in the same style are trying to sell at the same time, costly fire sales are more likely; therefore, temporary liquidity provision by the AFoMF are more likely to occur. AFoMFs favor distressed funds, if other funds in the distressed fund’s style are also selling.
The main reason AFoMFs offer liquidity to distressed members is because they strive to avoid costly liquidity driven trades. Additionally, the study suggests that liquidity induced mutual fund trading is costly.
Furthermore, the writers critique comments from mutual fund managers who suggest that the reason for targeting distressed mutual funds is due to valuation; the writers claim that the issue of liquidity remains vivid despite all these.