Mutual Fund Borrowing Poses Risk to Investors

A. Joseph Warburton holds a shared appointment at Syracuse University as Professor of Law at the College of Law and Professor of Finance at the Whitman School of Management and Michael Simkovic is Professor of Law and Accounting at the USC Gould School of Law. This post is based on their recent paper, forthcoming in the Journal of Empirical Legal Studies. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

Millions of Americans rely on mutual fund investments to pay for their retirement, but mutual funds contain hidden, previously under-appreciated risks.

Our new study, forthcoming in the Journal of Empirical Legal Studies, provides evidence that mutual funds borrow in an attempt to improve their performance. But those attempts not only fail to boost average returns, they also increase the volatility of returns, potentially creating serious problems for those who need to withdraw their money at a time when the market is down.

The Investment Company Act of 1940 permits mutual funds to have a capital structure that is up to one-third debt. Our paper is the first to study the performance of open-end funds that exploit their statutory borrowing authority.

We constructed a database using information contained in annual filings of open-end domestic equity funds covering 17 years from 2000 to 2016. A surprising number of funds—18 percent—bulked up at some point by borrowing money for leverage. These borrowing funds underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. After accounting for risk, borrowers underperform by 48 to 72 basis points annually. We find that funds borrow in an unsuccessful effort to juice performance after having lagged in the mutual fund rankings.

Mutual funds that borrow are plain-vanilla mutual funds, not exotic investment vehicles often associated with leverage, such as alternative funds and levered index funds. By contrast, we find that 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.

Concerned about leverage, regulators have recently been examining funds’ use of derivatives, but that focus may be too narrow as borrowing also presents a risk to investors. The SEC has recently proposed new rules on the use and reporting of derivatives by registered investment companies. Our paper suggests that regulators would benefit from collecting further data on mutual fund borrowing, to provide greater transparency into mutual fund capital structure.

The complete paper is available for download here.

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