A new study forthcoming in the Journal of Empirical Legal Studies provides evidence that mutual funds are borrowing in an attempt to improve their performance. But those attempts are not only falling short, they are creating more risk to investors who count on the funds to bolster their retirement savings.
“Economists often assume that open-end mutual funds do not leverage themselves by borrowing money, however the Investment Company Act of 1940 permits mutual funds to have a capital structure that is up to one-third debt,” said A. Joseph Warburton, professor of finance at Syracuse University’s Martin J. Whitman School of Management and professor of law at Syracuse University’s College of Law. “This paper is the first to study the performance of open-end funds that exploit their statutory borrowing authority.”
Warburton constructed a database using information contained in annual filings of open-end domestic equity mutual funds covering 17 years from 2000 to 2016. He found a surprising number of funds – 18 percent – bulked up at some point by borrowing in an effort to juice performance after lagging in the mutual fund rankings. Ironically, those that borrowed underperformed their non-borrowing peers by 62 basis points per year on a total return basis, incurring greater risk, as well.
“These borrowers are plain-vanilla mutual funds, not the exotic investment vehicles often associated with leverage, such as alternative funds and levered index funds,” said Warburton. “Most people think their 401(k)s are safe, but there is hidden risk in the investment vehicle millions of Americans rely upon for their retirement savings.”
Unlike borrowing, the study found funds that use derivatives and other financial instruments perform about as well as unlevered mutual funds, before and after adjusting for risk, and with less volatility. This suggests that many mutual funds use derivatives to hedge risk rather than as a substitute for leverage through the capital structure.
“Borrowing may present a greater risk than derivatives, which have received more attention than borrowing,” said Warburton. “The average investor is virtually unaware of how much a mutual fund is borrowing and the associated effect on performance,” said Warburton. “The required semi-annual reports have very little detail and it’s not easy to find.”
Warburton maintains that the Securities and Exchange Commission (SEC) is too focused on the use of derivatives, overlooking the potential crisis mutual fund borrowing presents. Fund investors and regulators would benefit from collecting further data on mutual fund borrowing to provide greater transparency into mutual fund capital structure.
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