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Review of Quantitative Finance and Accounting

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20-10-2015 | Original Research

Management of flow risk in mutual funds

Authors: Martin Rohleder, Dominik Schulte, Marco Wilkens

Published in: Review of Quantitative Finance and Accounting | Issue 1/2017

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Abstract

This paper is the first to relate the investment practices of U.S. equity mutual funds to their management of flow risk, defined as the adverse effect of investor in- and outflows on fund performance. Using a comprehensive merged sample of 2585 actively managed U.S. domestic equity funds from the CRSP mutual fund database and the SEC’s regulatory N-SAR filings, we are the first to detect differences in funds’ responses to flow risk. We find that funds using derivatives, such as options and futures on indices as well as individual stocks, have higher performance than non-using funds. We further show that this outperformance is the result of superior flow risk management using these derivatives and not a result of derivatives based stock-picking or market-timing activities. Overall, our findings document that superior flow management ability is valuable when managing open-end mutual funds and should be considered by investors and researches when evaluating fund performance.

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http://www.wsj.com/articles/sec-preps-mutual-fund-rules-1410137113 (accessed 04/13/2015).

See Table 20 of Investment Company Institute Fact Book, 2014.

ReFlow is a company offering so-called NAV swaps to its clients to help them manage the adverse impact of investor flows on performance. http://www.reflow.com/.

Cao et al. (2011) also use N-SAR data on derivatives use. However, they use a very short time interval from June 1996 to January 1998.

We elaborate on the regulation of mutual fund derivative use in Sect. 3.1 to provide a more detailed understanding of how such strategies work.

The asset coverage ratio is defined as the ratio of fund total net assets plus the market value of senior securities to the market value of senior securities.

For a detailed description of mutual fund investment practice regulation, see Chen et al. (2013).

We fill missing entries for TNA in CRSP similar to the procedure laid out in Rohleder et al. (2011).

Our results are robust to changing this threshold to $25 million.

Our results are robust to changing this threshold to 48 monthly observations.

N-SAR filings from the SEC are used in several other studies. Edelen (1999) investigates the impact of investor flows on fund trading behavior. Deli and Varma (2002) and Almazan et al. (2004) analyze fund investment restrictions. O’Neal (2004) studies gross investor flows. Reuter (2006) investigates the relation between underwriter commissions and initial public offerings, while Kuhnen (2009) and Warner and Wu (2011) analyze investment advisory contracts. Edelen et al. (2012) examine brokerage commissions. Cashman et al. (2012, 2014), Clifford et al. (2013), and Fulkerson et al. (2013) analyze the effect of performance on future gross investor flows. Christoffersen et al. (2013) focus on the relationship between gross investor flows and fees. Chen et al. (2013) investigate mutual funds using short sales. Evans et al. (2014) analyze security lending by mutual funds and Clifford et al. (2014) analyze the determinants of investment practice permission.

The N-SAR filings are available for download at http://www.sec.gov/edgar.shtml.

We thank Kenneth R. French for providing data on risk free rate, market, size, book-to-market, and momentum factors at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

Results are qualitatively the same when we use mean squared net flow instead of mean absolute net flows as a proxy for adverse investor flows.

In alternative specifications, the cross-sectional dummy derivatives is one if a fund uses derivatives at least 10, 25, 50, or 75 % of the time, respectively. The results remain the same. For brevity, these analyses are not reported in the main text, but available from the authors upon request.

To control for any self-selection bias arising from these self-imposed restrictions we use an additional propensity score matching analysis. The results to this test are in line with our main findings and presented in Sect. 5.1.

While Sapp and Tiwari (2004) argue that these findings are due to these studies not controlling for stock momentum, Keswani and Stolin (2008) show that even when controlling for momentum a smart money effect exists.

Additional propensity score analyses for the individual components of derivatives show similar results. For brevity, they are not reported in the paper but available from the authors upon request.

The conditioning variables are the S&P 500 dividend yield obtained from Thomson Reuters Datastream, the term spread (yield spread between 10-year treasury bond yield and 3-month treasury bill yield), the default spread (yield spread between BAA-rated and AAA-rated corporate bonds), and the 3-month treasury bill yield. We obtain all yield time-series from the St. Louis Federal Reserve website.

We thank Antii Petajisto for providing the data. http://www.petajisto.net/data.html.

We thank Robert F. Stambaugh for providing the time-series of the Pástor and Stambaugh (2003) liquidity factor on his website at http://finance.wharton.upenn.edu/~stambaugh/liq_data_1962_2012.txt.

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Title: Management of flow risk in mutual funds
Authors: Martin Rohleder
Dominik Schulte
Marco Wilkens
Publication date: 20-10-2015
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 1/2017
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-015-0541-1

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