The existing literature implicitly or explicitly assumes that securities lenders primarily respond to demand from borrowers and reinvest their cash collateral through short-term markets. Using a new dataset that matches every U.S. life insurer’s bond portfolio, as well as their lending and reinvestment decisions, to the universe of securities lending transactions, Foley-Fisher, Narajabad, and Verani offer compelling evidence for an alternative strategy, in which securities lending programs are used to finance a portfolio of long-dated assets. The researchers discuss how the liquidity and maturity mismatch associated with using securities lending as a source of wholesale funding could potentially impair the functioning of the securities market.
This paper was distributed as Working Paper 22774, where an updated version may be available.
Institutional investors paid asset managers average annual fees of $172 billion between 2000 and 2012. Gerakos, Linnainmaa, and Morse show that asset managers outperformed their benchmarks by 96 basis points per year before fees, and by 49 basis points after fees. Estimates from a Sharpe (1992) model suggest that asset managers achieved out-performance through factor exposures (“smart beta”). If institutions had instead implemented a long-only mean-variance efficient portfolio over the same factors via institutional mutual funds, they would have earned just as a high, but no higher, Sharpe ratio as by delegating to asset managers. Liquid, low-cost ETFs are likely eroding the comparative advantage of asset managers. Because asset managers account for 29% of investable assets, the adding-up constraint implies that the average dollar of everyone else had a negative alpha of 49 basis points.
Koijen and Yogo develop an asset pricing model with rich heterogeneity in asset demand across investors, designed to match institutional holdings. The equilibrium price vector is uniquely determined by market clearing for each asset. The researchers relate their model to traditional frameworks including Euler equations, mean-variance portfolio choice, factor models, and cross-sectional regressions on characteristics. They propose two identification strategies for the asset demand system, based on a coefficient restriction or instrumental variables, which produce similar estimates that are different from the least squares estimates. The authors apply their model to understand the role of institutions in stock market movements, liquidity, volatility, and predictability.
Managed portfolios that take less risk when volatility is high produce large alphas and substantially increase factor Sharpe ratios. Moreira and Muir document this for the market, value, momentum, profitability, return on equity, and investment factors in equities, as well as the currency carry trade. They find that volatility timing produces large utility gains and benefits both short- and long-horizon investors. Their strategy is contrary to conventional wisdom because it takes less risk in recessions and crises yet still earns high average returns. This rules out typical risk-based explanations and is a challenge to structural models of time-varying expected returns.
This paper was distributed as Working Paper 22208, where an updated version may be available.
Appel, Gormley, and Keim analyze whether the growing importance of passive investors has influenced the campaigns, tactics, and successes of activists. They find activists are more likely to pursue changes to corporate control or influence (e.g., via board representation) and to forego more incremental changes to corporate policies (e.g., via shareholder proposals) when a larger share of the target company’s stock is held by passively managed mutual funds. Furthermore, higher passive ownership is associated with increased use of hostile, expensive tactics (e.g., proxy fights) and a higher likelihood the activist obtains board representation or the sale of the targeted company. Overall, the findings suggest that the increasingly large ownership stakes of passive institutional investors mitigate free-rider problems associated with certain forms of intervention and ultimately increase the likelihood of success by activists.
Using a novel data set on the cash holdings of mutual funds, Chernenko and Sunderam show that cash plays a key role in how mutual funds provide liquidity to their investors. Consistent with the idea that they perform a significant amount of liquidity transformation, mutual funds use cash to accommodate inflows and outflows rather than transacting in equities or bonds, even at long horizons. This is particularly true for funds with illiquid assets and at times of low market liquidity. The researchers provide evidence suggesting that, despite their size, the cash holdings of mutual funds are not sufficiently large to fully mitigate price impact externalities created by the liquidity transformation they engage in.
This paper was distributed as Working Paper 22391, where an updated version may be available.
Evidence from a Regulatory Experiment
Concerned with excessive risk taking, regulators worldwide generally prohibit private pension funds from charging performance-based fees. Instead, the premise underlying the regulation of private pension schemes (and other retail-oriented funds) is that competition among fund managers should provide them with the adequate incentives to make investment decisions that would serve their clients’ long-term interests. Using a regulatory experiment from Israel, Hamdani, Kandel, Mugerman, and Yafeh compare the effects of incentive fees and competition on the performance of three exogenously-given types of long-term savings schemes operated by the same management companies: (i) funds with performance-based fees, facing no competition; (ii) funds with AUM-based fees, facing low competitive pressure; and (iii) funds with AUM-based fees, operating in a highly competitive environment. The main result is that funds with performance-based fees exhibit significantly higher risk-adjusted returns than other funds, but are not necessarily riskier (that depends on the measure of risk used). By contrast, the researchers find that competitive pressure leads to poor performance, and conclude that incentives and competition are not perfect substitutes in the retirement savings industry. Their analysis suggests that the pervasive regulatory restrictions on the use of performance-based fees in pension fund management may be costly for savers in the long-run and may need to be reconsidered.
Chuprinin and Sosyura study the relation between mutual fund managers’ family backgrounds and their professional performance. Using hand-collected data from individual Census records on the wealth and income of managers’ parents, the researchers find that managers from poor families deliver higher alphas than managers from rich families. This result is robust to alternative measures of fund performance, such as benchmark-adjusted return and value extracted from capital markets. The authors argue that managers born poor face higher entry barriers into asset management, and only the most skilled succeed. Consistent with this view, managers born rich are more likely to be promoted, while those born poor are promoted only if they outperform. Overall, the researchers establish the first link between family descent of investment professionals and their ability to create value.
This paper was distributed as Working Paper 22517, where an updated version may be available.
Eisfeldt, Lustig, and Zhang develop a dynamic equilibrium model of complex asset markets with endogenous entry and exit in which the investment technology of investors with more expertise is subject to less asset-specific risk. The joint equilibrium distribution of financial expertise and wealth then determines this asset market's risk bearing capacity. Higher expert demand lowers equilibrium required returns, reducing overall participation. In a dynamic industry equilibrium, investor participation in more complex asset markets with more asset-specific risk is lower, despite higher market-level Sharpe ratios, as long as asset complexity and expertise are complements. The researchers analyze how asset complexity affects the stationary wealth distribution of complex asset investors. Because of selection, increased complexity reduces expertise heterogeneity and wealth concentration, even though the wealth distribution for more expert investors has fatter tails.
Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism
Incentive Fees and Competition in Pension Funds: Evidence from a Regulatory Experiment
Family Descent as a Signal of Managerial Quality: Evidence from Mutual Funds