The organisation of the asset management industry and the benefits of closed-end structures

Mariassunta Giannetti, Bige Kahraman

Theoretical corrections of price deviations in trade are not reflected in empirical evidence. This is surprising because institutional investors should be able be able to identify mispricing. This column explores how the organisation of the asset management industry may hamper trading against mispricing. Asset managers that are less subject to redemption risk exhibit a higher propensity to trade against mispricing. Organisational structures lowering the sensitivity of investor flows to performance strengthen asset managers’ incentives to trade against mispricing.

In an efficient capital market, rational investors are expected to trade instantaneously when prices deviate from their fundamental values. However, plenty of empirical evidence shows that asset prices can deviate from their fundamental value for long periods of time (Lamont and Thaler 2003, Lamont and Stein 2004). This evidence is puzzling because an increasing amount of the trading volume can be attributed to institutional investors, which should have the skills and resources to identify mispricing. It is even more puzzling that intermediaries seem to trade in a way that accentuates mispricing (e.g. Brunneimer and Nagel 2004, Greenwood and Nagel 2009, Mitchell et al. 2007, Frazzini and Lamont 2008).

In a new paper, we ask whether the organisation of the asset management industry may hamper trading against mispricing (Giannetti and Kahraman 2016). This question is related to a long-standing debate on the organisation of the asset management industry. Most institutional investors are organised on an open-end basis – that is, the shares they issue to their investors can be redeemed on demand. Fama and Jensen (1983) argue that these open-end organisational structures prevail because they are the most efficient and guarantee the highest investor protection.

However, Stein (2005) shows in a theoretical model that the degree of open-ending in the market can be socially excessive because open-end organisational structures discourage asset managers from trading against mispricing. His theoretical argument builds on Shleifer and Vishny (1997). Asset managers invest other people’s money. Fund investors typically lack the specialised knowledge to evaluate an asset manager’s strategy, and may simply evaluate the manager on the basis of his recent past performance. If the long-term mispricing that a fund manager is exploiting fails to converge in the short run, investors may decide that the manager is incompetent and refuse to provide him with more capital, and even withdraw some of it. To avoid encountering such bad scenarios in the future, asset managers may neglect arbitrage opportunities for which convergence to fundamentals is unlikely to be either smooth or rapid. Only asset managers whose flows are less sensitive may thus be willing to undertake long-term and risky arbitrage.

To the best of our knowledge, we are the first to show empirically that asset managers that are less subject to redemption risk do exhibit a higher propensity to trade against mispricing. In this way, we highlight the features of asset managers’ organisational structures that better serve the useful social function of bringing prices to their fundamental value, and ultimately lead to an efficient capital allocation.

To test this hypothesis, we begin by contrasting the trading behaviour of open- and closed-end funds. Open- and closed-end funds are subject to similar regulations, but unlike open-end funds, assets under closed-end fund management do not depend on performance-driven investor flows. Therefore, we expect closed-end funds to be more inclined to undertake long-term arbitrage. Next, we exploit that hedge funds often impose share restrictions, constraining withdrawals. Share restrictions decrease the funds’ flow-performance sensitivity (Hombert and Thesmar 2014). We thus expect hedge funds with high share restrictions to be more inclined to trade against long-term mispricing than ones with low share restrictions. Finding that any differences between closed- and open-end funds are reproduced by hedge funds with high and low share restrictions would provide an independent validation of our hypothesis.

We exploit two alternative sources of mispricing, widely used in the literature, which determine undervaluation because of sudden drops in the demand of retail investors or some large institutional investors.

We find that closed-end funds are more inclined to buy undervalued stocks than open-end funds. The difference in the net purchases of closed- and open-end funds in fire sale stocks is about half of the standard deviation of all trades, indicating that the effects are not only statistically significant, but also economically so. Differences in trading behaviour are even more pronounced for stocks with high arbitrage risk (such as smaller stocks and stocks with highly volatile returns), as predicted by Shleifer and Vishny (1997).

Similarly, hedge funds with higher share restrictions have more investments in undervalued stocks compared to other hedge funds. The differences in trading associated with share restrictions, although statistically and economically significant, are somewhat less pronounced than the ones between closed- and open-end funds, suggesting that high share restrictions insulate managers from performance-sensitive flows to a lesser extent.

Not only are our findings robust across different classes of asset managers, but they also survive a battery of robustness checks that aim to rule out that certain fund characteristics, correlated with the fund’s organisational structure (such as the fund’s style or the fund manager’s ability), drive our findings. For instance, fund managers that co-manage open- and closed-end funds trade more against mispricing in their closed-end funds, suggesting that our results are not driven by differences in managerial ability. In addition, open-end funds appear less likely to purchase fire sale stocks even when we control for various measures of the funds’ financial slack, confirming the hypothesis that the incentives arising from funds’ organisational structures matter.

Finally, the cross-sectional variation of the effects supports the mechanisms upon which our interpretation of the findings relies. First, we find that the differences in trading between open- and closed-end funds are particularly pronounced for open-end funds with high flow-performance sensitivity. Similarly, open-end funds that are run by managers with longer tenures are more inclined to invest in long-term arbitrage opportunities – arguably, because investors have learnt more about their skills, and thus are less likely to respond to their performance. Taken jointly, our tests highlight that organisational structures lowering the sensitivity of flows to performance strengthen asset managers’ incentives to trade against mispricing.

Our paper highlights one benefit of the closed-end fund structure (and share restrictions) on the asset managers’ propensity to trade against mispricing. While our analysis is silent about the potential costs of closed-end fund structures, Wu et al. (2013) suggest that managerial career concerns and the labour market may provide discipline to closed-end fund managers. This would suggest that more share restrictions and close-end structures might be optimal. We leave these questions for future research.

References

Brunnermeier, M, and S Nagel (2004), “Hedge funds and the technology bubble”, Journal of Finance 59, 2013–2040

Fama, E F, and M C Jensen (1983), “Agency problems and residual claims”, Journal of Law and Economics, 26, 327–349

Frazzini, A, and O Lamont (2008), “Dumb money: Mutual Fund Flows and the Cross-Section of Stock Returns”, Journal of Financial Economics 88, 299–322

Giannetti, M, and B Kahraman, “Who trades against mispricing?”, CEPR Discussion Paper no. 11156

Greenwood, R, and S Nagel (2009), “Inexperienced investors and bubbles”, Journal of Financial Economics 93, 239–258.

Lamont, O A, and J C Stein (2004), “Aggregate Short Interest and Market Valuations”, American Economic Review, 29-32

Lamont, O A, and R H Thaler (2003), “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs”, Journal of Political Economy, 111 (2)

Mitchell, M, L H Pedersen, and T Pulvino (2007), “Slow Moving Capital”, American Economic Review 97, 215–220

Shleifer, A, and R W Vishny (1997), “The Limits of Arbitrage”, Journal of Finance 52, 35-55

Stein, J C (2005), “Why are most funds open-end? Competition and the limits to arbitrage”, Quarterly Journal of Economics 120, 247–72

Wu, Y, R Wermers, and J Zechner (2013), “Managerial rents vs. shareholder value in delegated portfolio management: the case of closed-end funds”, available at SSRN