Mutual Funds that Borrow

Journal of Empirical Legal Studies, Forthcoming

57 Pages Posted: 7 Jun 2019 Last revised: 7 Aug 2019

See all articles by A. Joseph Warburton

A. Joseph Warburton

Syracuse University - College of Law; Syracuse University - Whitman School of Management

Michael Simkovic

University of Southern California Gould School of Law; University of Southern California - Marshall School of Business

Date Written: May 21, 2019

Abstract

Securities laws prohibit open-end mutual funds from borrowing more than one third of their capital structure because of concerns that too much borrowing may harm investors. This is the first paper to examine the performance of open-end funds that borrow money within these permissible limits. We construct a database from annual filings of open-end domestic equity mutual funds covering 17 years from 2000 to 2016. Eighteen percent of funds borrowed money for leverage within that time. We find that borrowing funds underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. After accommodating for the greater risk taking, we find that borrowers underperform by 48 to 72 basis points annually. By contrast, funds that use derivatives and other financial instruments perform about as well as unlevered mutual funds, before and after adjusting for risk, and with less volatility. This suggests that many mutual funds use derivatives to hedge risk rather than as a substitute for leverage through the capital structure. Thus borrowing may present a greater risk than derivatives, which have received more attention than borrowing. Fund investors and regulators would benefit from greater transparency into mutual fund capital structure.

Keywords: mutual funds, investment companies, leverage, borrowing, capital structure, derivatives

Suggested Citation

Warburton, A. Joseph and Simkovic, Michael, Mutual Funds that Borrow (May 21, 2019). Journal of Empirical Legal Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3392079 or http://dx.doi.org/10.2139/ssrn.3392079

A. Joseph Warburton (Contact Author)

Syracuse University - College of Law ( email )

Syracuse, NY 13244-1030
United States

Syracuse University - Whitman School of Management ( email )

Syracuse, NY
United States

Michael Simkovic

University of Southern California Gould School of Law ( email )

699 Exposition Boulevard
Los Angeles, CA 90089
United States

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States

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