Payoff complementarities and financial fragility: Evidence from mutual fund outflows

Abstract

The paper provides empirical evidence that strategic complementarities among investors generate fragility in financial markets. Analyzing mutual fund data, we find that, consistent with a theoretical model, funds with illiquid assets (where complementarities are stronger) exhibit stronger sensitivity of outflows to bad past performance than funds with liquid assets. We also find that this pattern disappears in funds where the shareholder base is composed mostly of large investors. We present further evidence that these results are not attributable to alternative explanations based on the informativeness of past performance or on clientele effects. We analyze the implications for funds’ performance and policies.

Introduction

Financial fragility is often attributed to the presence of strategic complementarities among investors.¹ When investors’ incentive to take a certain action increases in the expectation that other investors will take the same action, a multiplier effect is expected to emerge, amplifying the effect of fundamentals on investors’ behavior. Despite a large theoretical literature, virtually no empirical study identifies this relation in data. This paper aims to provide such empirical evidence.

We conduct our study using (open-end) mutual fund data. In mutual funds, investors have the right to redeem their shares at the fund's daily-close net asset value (NAV) on any given day. As shown in previous studies (e.g., Edelen, 1999, Coval and Stafford, 2006), following substantial outflows, funds need to adjust their portfolios and conduct costly and unprofitable trades, which damage the future returns. Because mutual funds conduct most of the resulting trades after the day of redemption, most of the costs are not reflected in the NAV paid out to redeeming investors, but rather are borne by the remaining investors. This leads to strategic complementarities—the expectation that other investors will withdraw their money reduces the expected return from staying in the fund and increases the incentive for each individual investor to withdraw as well—and amplifies the damage to the fund.

Detecting this mechanism in the data is a difficult task. Testing directly whether agents choose the same action as others cannot credibly identify the effects of strategic complementarities because this approach is prone to a missing variable problem, that is, agents could act alike because they are subject to some common shocks or react to information about fundamentals unobserved by the econometrician. This so-called reflection problem posed a challenge for empiricists trying to detect peer effects for a long time (see discussion by Manski, 1993; Glaeser, Sacerdote, and Scheinkman, 2003). Recently, Hertzberg, Liberti, and Paravisini (2009) resort to a special setting that generates discontinuity in the information variable for identification. Instead, our empirical approach relies on the differences across mutual funds in the level of strategic complementarities faced by their investors. Investors in funds that hold illiquid assets (hereafter, illiquid funds) face a higher degree of strategic complementarities than investors in funds that hold liquid assets (hereafter, liquid funds). This is because redemptions impose higher costs on the illiquid funds than the liquid funds. Our empirical analysis tests for differences in redemption patterns across these types of funds.

We start by developing a stylized model of mutual fund redemptions that delivers our basic hypotheses. Given that the basic premise of the model is the presence of strategic complementarities in mutual fund redemptions, getting empirical predictions is non-trivial. This is because models with strategic complementarities typically have multiple equilibria and thus cannot be easily taken to the data.² Our theoretical model (detailed in the Appendix) uses the global-game framework (assuming that agents do not have common knowledge about some fundamental variable that affects the returns of the fund) to overcome the problem of multiple equilibria and generate clear-cut empirical predictions.³

Our main hypothesis is that the sensitivity of outflows to bad past performance is stronger in illiquid funds than in liquid funds. Intuitively, consider investors holding shares in an emerging market fund versus investors holding shares in a fund that invests in large-cap US stocks. Faced with bad performance, the former have a stronger tendency to redeem their shares because they know that redemptions by others impose non-negligible costs on the fund, which hurts them if they choose to stay in the fund. Our second prediction is based on the idea that large investors are more likely to internalize the externalities in redemptions. Knowing that they control large shares of the fund assets, large investors are less concerned about the behavior of others. Hence, the prediction is that the effect of the illiquidity of fund assets on investors’ redemptions is smaller in funds held primarily by large investors.⁴ Using data on the net outflows from US equity mutual funds from 1995 to 2005 and various measures of illiquidity (captured either by the stated investment style or the trading liquidity of the underlying assets), we find strong support for our two hypotheses.

We consider two alternative explanations for our findings. The first one is reminiscent of the empirical literature that attributes banking failures to bad fundamentals (e.g., Gorton, 1988, Calomiris and Mason, 1997, Calomiris and Mason, 2003, Schumacher, 2000, Martinez-Peria and Schmukler, 2001). In our context, illiquid funds could see more outflows upon bad performance because their performance is more persistent, and so, even without considering the outflows by other shareholders, bad performance increases the incentive to redeem. We entertain this explanation by examining in data whether, absent large outflows, performance in illiquid funds is more persistent than in liquid funds. We find no such evidence, both for open-end funds (after excluding observations with extremely large outflows) and for closed-end funds (where, by definition, outflows do not exist).

The second alternative explanation is based on a clientele effect. Suppose that investors in illiquid funds are more tuned to the market than investors in liquid funds, and thus they redeem more promptly after bad performance. We address this point by analyzing the behavior of one sophisticated clientele, institutional investors. We show that in the subsample of retail-oriented funds where strategic complementarities are expected to have an effect, large investors’ redemptions are more sensitive to bad performance in illiquid funds than in liquid funds. Moreover, this result does not hold in the subsample of institutional-oriented funds. These results suggest that the clientele effect is not driving our results. An interesting aspect of the result is that institutional investors behave differently, depending on whether they are surrounded by other institutional investors or by retail investors. These differences provide a key piece of evidence to identify the role of strategic interaction in mutual fund redemptions.

Finally, we provide two additional pieces of evidence that support the mechanism of our story. First, our story relies on the idea that outflows in illiquid funds cause more damage to future performance. We confirm this premise in the data. Second, given that outflows are much costlier for illiquid funds, one would expect illiquid funds to be more inclined to taking measures to either reduce the frequency of trading or minimize their impact on fund performance. Such measures include restrictions on redemptions after a 2005 Securities and Exchange Commission (SEC) rule and holding more cash reserves. We find that illiquid funds are more likely to take each one of the two measures. Hence, the effects we detect in equilibrium are observed after the mitigating effect of these measures.

The institutional features of mutual funds that motivate our study possibly facilitate occasional extreme turbulences, such as the run on the money market funds in the US during the midst of the subprime crisis in September 2008.⁵ To benefit from the richness and diversity of the mutual fund data, we deliberately use a large sample instead of confining ourselves to short periods and selected funds in which extreme turbulences occurred. In particular, our ability to distinguish between funds with different degrees of strategic complementarities and with different types of investors is crucial for testing our hypotheses and for ruling out the alternative explanations. While looking at a large sample that consists mostly of calm periods reduces the magnitude of the mechanism we are interested in, we are still able to find evidence to support our hypotheses.⁶

Our findings manifest the vulnerability of mutual funds and other open-end financial institutions. The fact that open-end funds offer demandable claims is responsible for the strategic complementarities and their destabilizing consequences. This opens questions on optimal fund policies and regulation. For example, our results suggest that this fragility is tightly linked to the level of liquidity of the fund's underlying assets and that funds investing in highly illiquid assets may be better off operating in a closed-end form. This idea underlies the model of Cherkes, Sagi, and Stanton (2006). Yet, as pointed out by Stein (2005), in equilibrium, due to signaling considerations, an inefficiently high proportion of open-end funds exists. Our study suggests that this is particularly damaging for funds that hold illiquid assets. Beyond the funds and their investors, this fragility has important implications for the workings of financial markets. Financial fragility prevents open-end funds from conducting various kinds of profitable arbitrage activities (see Stein, 2005) and thus promotes mispricing and other related phenomena.

Our paper also contributes to the mutual fund literature. Many papers study mutual fund flows. A partial list includes Brown, Harlow, and Starks (1996), Chevalier and Ellison (1997), Sirri and Tufano (1998), and Zheng (1999). Our results imply that investors’ redemption decisions are affected by what they believe other investors will do. Also, not knowing what other investors will do, mutual fund investors are subject to a strategic risk due to the externalities from other investors’ redemptions. This brings a new dimension to the literature on fund flows, which thus far has not considered the interaction among fund investors.

The remainder of the paper is organized as follows. In Section 2, we describe the institutional details that support the design of our study and present the main hypotheses (the model on which the hypotheses are based is provided in Appendix). In Section 3, we describe the data used for our empirical study. In Section 4, we test our hypotheses regarding the effect of funds’ liquidity and investor base on outflows. Section 5 considers the potential alternative explanations and provides evidence to rule them out. In Section 6, we provide robustness checks and further evidence. Section 7 concludes.