For years, there has been some concern that firms offering target-date and lifestyle "funds-of-funds" propped up their laggards and losers by using sister funds to cross-invest. Now an Indiana University study takes on that topic.
A controversial new academic study says that mutual-fund sponsors are using assets in a popular type of long-term holding to prop up sister funds that are struggling, at some unknown cost to investors.
At a minimum, according to the Indiana University study, investors in affiliated fund-of-funds — the structure for the vast majority of life-cycle and target-date funds and college-savings plans — are exposed to a conflict of interest. At worst, that conflict diminishes returns.
There has been a buzz in the industry about this study — “Conflicting Family Values in Mutual Fund Families” — since a draft version was presented to an industry conference last fall, but now that the study is being released in the Journal of Finance, it will become a popular topic, especially because so many people use fund-of-funds as a default choice for their long-term savings goals.
In order for life-cycle and target-date investors to decide how they want to respond to the allegations raised by the research, let’s delve into the study.
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Fund-of-funds are mutual funds that invest entirely in other funds. An “affiliated fund-of-funds” invests entirely in siblings run by the same management firm; it is how most firms run target-date funds, following an asset-allocation plan that spreads money into several sisters.
For years, there has been some concern that firms propped up their laggards and losers this way. It’s what industry critics assumed was keeping assets flowing into Vanguard U.S. Growth (VWUSX) — one of Vanguard’s disappointing performers — long after performance had faltered. There are similar examples in almost every major fund family, where the fund-of-funds share the wealth with both good and bad siblings.
The Indiana researchers wanted to see if fund families allocated money into funds that were facing big redemptions or bad performance. Because each fund is an independent entity — even though they are run by the same sponsor — each should be operated with a shareholder-first mentality, and not run in a way that puts the sponsor’s interest first.
The study — using data from October 2002 to January 2008 — found that fund sponsors used the house fund-of-funds as “insurance pools” to offset shortfalls when its managed issues were distressed.
For example, if a firm’s emerging markets fund is facing significant withdrawals, the sister fund-of-funds gets a hankering for emerging-market holdings; its investment provides liquidity to the sister fund.
The real question is whether those fund-of-funds needed that new allocation to, say, emerging markets. If not — and most fund-of-funds have static allocations that change slowly over time — fund firms are putting their own interests ahead of shareholders.
“Because shareholders in these (life-cycle and target-date) types of funds are so passive, holding their shares in retirement accounts, the fund sponsor can move the money around without worrying that the fund-of-funds will be facing its own withdrawals,” said Veronika Pool, one of the IU researchers. “You can say there is some harm to shareholders going on, because every time an investment occurs for reasons other than that it is a good investment opportunity, the underlying shareholders are paying the costs.”
No one is saying that it is illegal for the firm to follow its own agenda. Fund firms operate under certain rules exceptions that allow for cross-trading and other activities, although those actions should be disclosed in a fund’s prospectus and the Indiana academics say it isn’t always laid out there.
There’s also a significant question as to how much the practice actually costs shareholders. Big redemptions can hurt an underlying fund; thus, if a fund-of-fund buys more of a fund while others are running away, it is helping to reduce damage that shareholders would suffer if nothing was done and there was a run on the underlying fund.
What’s more, affiliated fund-of-funds typically waive costs, so while this conflict of interest doesn’t show up when a fund-of-fund invests outside its own borders, investors are paying more to own those nonaffiliated funds, and Pool said the higher costs almost certainly outweigh any costs created by the conflict of interest.
Further, the researchers noted that the house funds don’t prop up funds that are hurt by lousy management; sibling loyalty only goes so far, according to the study, and the cash-flow stops when it’s bad results, rather than market conditions, putting pressure on a sibling fund.
The ethical questions are unavoidable, however. While fund-of-fund managers can say they’re not doing anything untoward — insisting they really wanted to make those investments — only a forensic accounting and economics team could ever tell for sure.
For investors who want to avoid the conflicts, Pool suggests they look at the holdings in the life-cycle and target-date funds and loosely approximate the portfolios on their own.
“Obviously, investors can decide on their own allocation and not have these problems,” Pool said, “and they should understand when they invest in an affiliated fund-of-funds that what they are getting is convenience, and this is one of the prices they pay for that convenience.”
Chuck Jaffe is senior columnist
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