Mutual Funds that Borrow

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Author Information : A. Joseph Warburton (Syracuse University)
Michael Simkovic (University of Southern California)

Year of Publication : Journal of Empirical Legal Studies, 2019

Summary of Findings : A surprising number of mutual funds bulk up by borrowing money from banks. They borrow to juice performance after lagging in the mutual fund rankings, but this borrowing tends to hurt performance and increase risk for investors. These borrowers are plain-vanilla mutual funds, not the exotic investment vehicles often associated with leverage (such as “liquid-alt” funds and levered index funds). 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.

Research Questions : Do mutual funds exploit their ability to borrow money under Investment Company Act of 1940?

Does borrowing impact the performance of these funds (their risk and returns)?

Is borrowing different from financial instruments such as derivatives?

Why do mutual funds borrow money?

What we know : A surprising number of mutual funds (eighteen percent of domestic equity funds) borrowed money within the time period studied (2000 to 2016). Borrowers underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. After accommodating for the greater risk taking, borrowers underperform by 48 to 72 basis points annually.
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 funds use derivatives to hedge risk. Thus borrowing may present a greater risk than derivatives, which have received more attention than borrowing. There is evidence that funds borrow in a (generally unsuccessful) attempt to catch up to better-performing peers by year-end.

Novel Findings : 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. This paper is the first to study the performance of open-end funds that exploit their statutory borrowing authority.

Implications for Policy: While the Securities and Exchange Commission recognizes risks associated with mutual fund borrowing, its policies have largely focused on derivatives. National regulators must collect further data on mutual fund borrowing and require more transparent reporting of that borrowing.

Implications for Society: Americans who have 401(k) retirement accounts should be aware of the risks associated with mutual funds in those accounts. While reporting is not as transparent as it could be today, account holders can and should request a semi-annual report, which does include detail on borrowing.

Implications on Research: Securities laws prohibit open-end mutual funds from borrowing more than one third of their capital structure because of concerns that too much borrowing may harm investors. This is the first paper to examine the performance of open-end funds that borrow money within these permissible limits.

Full Citations : A. Joseph Warburton and Michael Simkovic, Mutual Funds that Borrow (Journal of Empirical Legal Studies, 2019).

Abstract : Securities laws prohibit open-end mutual funds from borrowing more than one third of their capital structure because of concerns that too much borrowing may harm investors. This is the first paper to examine the performance of open-end funds that borrow money within these permissible limits. We construct a database from annual filings of open-end domestic equity mutual funds covering 17 years from 2000 to 2016. Eighteen percent of funds borrowed money for leverage within that time. We find that borrowing funds underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. After accommodating for the greater risk taking, we find that borrowers underperform by 48 to 72 basis points annually. By contrast, 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. Thus borrowing may present a greater risk than derivatives, which have received more attention than borrowing. Fund investors and regulators would benefit from greater transparency into mutual fund capital structure.

Click here to access Full Paper

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. This paper is the first to study the performance of open-end funds that exploit their statutory borrowing authority.

A. Joseph Warburton

Professor Warburton researches corporate finance, corporate governance, financial regulation, and law and finance.His research is largely empirical, and focuses on areas where law and finance intersect. Warburton’s research has attracted significant outside funding, including major research grants from the John Templeton Foundation and the World Bank.
A. Joseph Warburton

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