Do Mutual Funds Underperform Hedge Funds? [STUDY]

Sophie Shive and Hayong Yun

University of Notre Dame

October 24, 2011

Institutional capital is relatively patient. This provides an opportunity for institutions to profit from predictable, investor-flow-induced mutual fund trades. Cash must be available for mutual fund investors to withdraw on short notice, and there are extensive limitations on which assets mutual funds can invest in, along with detailed portfolio disclosure requirements. Hedge funds, which cater to more sophisticated investors, are free to choose portfolios and leverage, as well as when to return capital to investors.

While these regulations were meant to protect mutual fund investors, they may instead harm them by making mutual funds too predictable, as Wermers (2001) anticipates in an article in the Investment Company Institutes Perspective: Front running of mutual fund trades could¬†signifi cantly increase, which could increase fund trading costs.”

Berk and Green (2004) show theoretically that mutual fund investors rationally chase fund returns, making fund flows predictable and good candidates for predation. Brunnermeier and Pedersen (2005) show that predatory trading, trading that induces and /or exploits the need of other investors to reduce their positions, is pro table for the predators, harmful to the victims, and aff ects prices. Recent empirical work (e.g., Warther, 1995; Coval and Sta ord, 2007; Lou, 2010; Ben-Rephael, Kandel, and Wohl, 2011) nds that investor ows into mutual funds, in aggregate or at the fund level, are robustly related to past flows and returns at various horizons. Wermers, Yao, and Zhao (2010) show that publicly disclosed mutual fund portfolio holdings contain valuable information on future returns. Mutual funds are also predictable in their response to flows. Coval and Stafford (2007) and Lou (2010) nd that mutual funds tend to expand and contract their portfolios in their existing proportions, which enables one to predict which stocks the funds will trade. Coval and Sta ord (2007) also show that front running anticipated trades by distressed mutual funds is a pro table strategy. This evidence may have fallen on receptive institutional ears.

Perhaps relatedly, Ackermann, McEnally, and Ravenscraft (1999) find that hedge funds earn relatively high abnormal returns. Agarwal, Daniel, and Naik (2009) show that funds with a higher degree of managerial discretion, approximated by longer lockup, notice, and redemption periods, deliver superior performance.4 Some of these excess returns to patient capital could be related to anticipation of mutual fund flows and trades. Research also fi nds that increased disclosure is related to lower mutual fund performance. Parida and Teo (2010) nd that funds reporting semi-annually outperform quarterly funds; this gap disappears after 2004, when all funds are required to report quarterly.

In this paper, we explore whether institutions, and hedge funds in particular, profi tably trade on anticipated aggregate mutual fund flows. Since 13F fi lings only present long positions, we focus on the relationship between changes in institutional long positions and predicted aggregate mutual fund flows. Our focus on aggregate mutual fund
flows is diff erent from Brunnermeier and Pedersen (2005) and Coval and Sta fford (2007), who focus on the more targeted type of predation of individual distressed funds. Also, given that our study only captures institutional long positions, our estimate of anticipatory trading is most likely conservative.

We make several contributions to the literature. First, we show that 13F ling institutions of types 4 and 5 (independent investment advisers and other institutions that are not banks, insurance companies or mutual funds), and hedge funds in particular, trade on quarter-ahead expected mutual fund flows in the 2003-2010 period. Using past work as a guide, our prediction model uses lagged flows and mutual fund returns as predictors and the fact that mutual funds tend to scale their existing portfolios up or down in response to flows.

H/T Alpha Architect

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