The vast majority of financial trades take place in open and highly regulated markets. However, asset managers from mutual fund families sometimes offset their trades with affiliated funds in an internal market. Such cross-trading can allow fund families to shift performance from poorly performing funds to better performing funds, artificially inflating their returns.
Research shows that fund families have incentives to use cross-trades to allocate “extra” performance to popular funds, because outperformers not only attract disproportionate inflows to themselves, but also have positive spillover effects on other funds run by the firm.
Alexander Eisele, Tamara Nefedova and Gianpaolo Parise are the authors of the August 2016 Bank for International Settlements working paper, “Are Star Funds Really Shining? Cross-Trading and Performance Shifting in Mutual Fund Families.” They sought to determine whether fund families actively favor their “stars” at the expense of their least valuable units.
The authors note that the agency issue of favoring one fund at the expense of another within a fund family has become increasingly important as “around 40% of all U.S. stock trades take today place outside of public exchanges, up from 16% in 2008. Alternative trading practices mostly include dark pool trading, internalizers, and cross-trades.” Cross-trades among affiliated funds are permitted under Rule 17a-7 of the U.S. Investment Company Act because such trades can, at least in principle, limit transaction costs and commissions, benefiting the final investor.
The Study & Its Results
Eisele, Nefedova and Parise used a sample of trades executed by American asset managers from 1999 to 2010 to be able to identify cross-trades correctly. The final number of asset managers in their sample represented 203 fund families managing 1,393 mutual funds.
The sample consisted of almost one million trades, out of which greater than 7,000 were classified as cross-trades—specifically, a pair of trades originated from the same asset manager, in the same stock, in the same quantity and executed at exactly the same day, time and price but displaying opposite trading directions.
Following is a summary of their findings:
- Contrary to the rationale supporting lower execution costs, cross-trades used to—prior to 2004, when stronger regulations were introduced following an investigation that uncovered widespread malpractice in industry practices—exhibit an execution shortfall 18 basis points higher than for trades executed in the open market after controlling for the size of the trade and stock, time and family-fixed effects. The trades were used to favor the “star” fund at the expense of the more poorly performing fund. However, this cost disappeared when restrictive regulation was introduced. Note that cross-trading went from peaks above 6 percent of total trading activity before the new regulation was introduced to below 1 percent afterward, and the shortfall disappeared.
- Cross-trades are significantly bigger than normal trades both in share and dollar volume, and tend to involve stocks that present higher bid-ask spreads and which are more volatile.
- Cross-trades presented larger deviations from benchmark prices when the exchanged stocks were illiquid and highly volatile, during periods of high financial uncertainty, and when the asset manager had weak governance, large internal markets and a strong incentive for reallocating performance.
- Cross-trades are more likely than open-market trades to be executed exactly at the highest or lowest price of the day, consistent with the ex-post setting (backdating) of the price to favor the “star” fund.
Perhaps the authors’ most important finding was that cross-trading potentially boosted the risk-adjusted performance of star funds by roughly 1.7 percent per year on average (causing an equivalent loss for the least important funds). As they noted: “This result casts doubt on the fraction of performance delivered by mutual funds that is really due to skill.” Said another way, cross-trading helps explain the cross-section of expected returns. What may appear to be alpha could be nothing more than expense shifting.
Cross-Trading Distorts Performance
While the authors concluded that “careful regulatory scrutiny seems to be highly effective in limiting both the extent of mispricing and the incentive to cross-trade,” they also acknowledge that their results suggest “that cross-trading activity widens the gap in performance between star and junk funds.”
They also observed that the focus of their analysis was on cross-trading activity. However, cross-trades are only one alternative to trading in open exchanges. For instance, large asset managers increasingly rely on “dark pools” and other opaque trading venues.
The authors write: “Overall, our findings point to potential risks posed by the increasing popularity of unsupervised and less regulated trading.” They also note that, consistent with the hypothesis of preferential treatment, fund families are incentivized to start new funds (including what are called incubator funds) and give other funds preferential treatment, thereby increasing their chances of producing a “star” fund. Along the same lines, research has shown that fund families use allocations to hot IPOs to provide preferential treatment, creating the illusion of management skill.
In our book, “The Incredible Shrinking Alpha,” my co-author, Andrew Berkin, and I present four themes that help explain why the percentage of actively managed funds generating statistically significant alpha has dropped from about 20 percent 20 years ago to about 2 percent today.
Those themes are: academic research is converting what once was alpha into beta, there is a shrinking pool of victims that can be exploited, competition from more skilled fund managers is increasing and there is an increased supply of capital chasing alpha. Eisele, Nefedova and Parise provide us with yet another contributing factor—tougher regulations have reduced the ability of fund families to transfer profits to their “stars.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.