About 40% of mutual funds are run by asset management divisions of groups whose primary activity is commercial banking. This creates a potential conflict of interest—fund managers who are employees of commercial (or investment) banking organizations may act in ways that benefit their organizations’ interests at the expense of fund investors.
Alternatively, lending could generate private information about borrowers via credit origination, monitoring and renegotiation that is valuable for the bank-affiliated fund manager, providing an exploitable advantage for fund investors.
However, at least in the U.S., organizations are required to impose “Chinese walls” to prevent communication between the asset management and the lending divisions so that affiliated funds operate independently of other bank divisions.
Miguel Ferreira, Pedro Matos and Pedro Pires investigated these two hypotheses in their study “Asset Management Within Commercial Banking Groups: International Evidence,” which was published in the October 2018 issue of the Journal of Finance. The study covered 28 countries and 7,220 domestic equity funds over the period 2000 through 2010. They focused their tests on actively managed funds that invest in domestic equities, because banks typically have stronger lending relationships with domestic firms.
Following is a summary of their findings:
- Bank-affiliated funds underperform unaffiliated funds by 92 basis points per year as measured by four-factor (beta, size, value and momentum) alphas. The results were robust to alternative measures such as benchmark indices.
- Bank-affiliated funds’ portfolio holdings are biased toward client stocks over nonclient stocks. On average, affiliated funds have about 15% of their holdings in client stocks, about 6% percentage points more than comparable passive funds hold of the same stocks.
- The client stock a fund buys underperforms the client stock a fund sells in the group of funds that overweight more client stocks. However, they do not underperform in the trading of nonclient stocks.
- Bank-affiliated funds with higher exposure to client stocks (in excess of the portfolio weights in passive funds that track the same benchmark) tend to underperform more.
- Bank-affiliated funds underperform more when the ratio of outstanding loans to assets under management is higher—most of the underperformance of bank-affiliated funds is explained by the size of the lending business of the banking group.
- Consistent with conflicts of interest, the underperformance is more pronounced among those affiliated funds that overweight more the stock of the bank’s lending clients.
- Funds affiliated with financial conglomerates with both relevant commercial and investment banking activity underperform by 0.5% percentage points per year.
- The underperformance of bank-affiliated funds is more pronounced in countries where there is high concentration in the fund industry (41 basis points per quarter) than where there is low concentration (20 basis points per quarter).
- While international funds affiliated with a commercial banking group underperform unaffiliated funds, the source of this underperformance is not driven by conflicts of interest with the lending division.
- Funds that switch from bank-affiliated to unaffiliated through divestiture subsequently significantly reduce their holdings of client stocks and experience improved performance. While supporting the conflict of interest hypothesis, it also suggests that the results are not driven by systematic differences in manager skill.
- The sensitivity of afﬁliated fund ﬂows to poor performance is statistically insigniﬁcant, suggesting that afﬁliated fund investors (typically, retail investors) exhibit inertia.
Of interest was the finding that banks are more likely to act as lead arrangers in future loans when they exert control over borrowers by holding shares through their asset management divisions—these holdings increase the probability of initiating a new lending relationship and preserving a past lending relationship.
As an example, Ferreira, Matos and Pires cite the JPMorgan U.S. Equity Fund, which is managed by J.P. Morgan Asset Management. Three of its top five holdings were classified as client stocks for which J.P. Morgan acted as lead arranger over the previous three years. The fund had 40.4% of its assets invested in client stocks, corresponding to an overweight of 7.2 percentage points compared to passive funds that track the S&P 500 Index.
The authors also found that fund managers who act as team players for their banking group employer by overweighting client stocks are less likely to lose jobs—suggesting that career concerns help explain the decision of fund managers to go along with the parent bank’s interests.
Another important finding was that conflicts of interest are more pronounced during bear markets, when a bank’s balance sheet would suffer the most from deterioration in the pricing of loans, borrowers are more likely to benefit from support, and fund managers have heightened career concerns.
A related finding was that affiliated funds increase their ownership of client stocks in periods of high selling pressure by other funds—evidence that they provide price support at the time of negative shocks, biasing their portfolios toward poorer-performing client stocks.
Regulations Can Reduce Conflicts Of Interests
Consistent with the idea that stronger regulations and competition mitigate conflicts of interest, Ferreira, Matos and Pires found that in the sample of U.S.-domiciled funds, where Chinese walls are required, there is less pronounced underperformance and no relation between performance and measures of conflicts of interest with the lending division.
They also found less underperformance for bank-affiliated funds domiciled in countries with common law (versus civil law) legal origins, market-based financial systems, higher regulatory requirements for fund approval and disclosure, and more competitive banking and mutual fund industries.
Summarizing, the authors concluded: “Overall, our results suggest that the underperformance of commercial bank-affiliated funds results from a double agency problem in that portfolio managers put aside the interests of one principal (the fund investor) in order to benefit another principal (the parent bank). Our findings have important implications, as about 40% of mutual funds worldwide do not operate as standalone entities, but rather as divisions of commercial banking groups.”
Given the results, it is not surprising that Ferreira, Matos and Pires found that commercial bank-affiliated funds have been losing market share in the U.S. However, they found that, outside the U.S., they still have an important market share.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.