The open-end structure of most investment vehicles discourages asset-managers from trading against mispricing – to the detriment of investors and market efficiency, Oxford research has shown.
‘The findings from my study, co-authored with Professor Mariassunta Giannetti from the Stockholm School of Economics, raise the question of why so many financial institutions are open-ended, when the structure actually incentivises against arbitrage,’ said Associate Professor of Finance Bige Kahraman, Saïd Business School, University of Oxford. ‘An open-end structure, in which investors can react to perceived under-performance by withdrawing capital, leads to short-termism and a persistent over- or under-valuing of assets.’
Dr Giannetti and Kahraman’s recent paper, Who Trades Against Mispricing? (Center for Economic Policy Research (CEPR) Working Paper Series CEPR WP 11156), shows how organisational structure affects fund managers’ incentives to profit from trading against under- or overpriced assets. Based on an analysis of about 1,500 US-based funds over 20 years, the paper looked at differences in investment behaviour by managers of open-ended funds, in which investors can invest or withdraw capital at any time; closed-end funds, in which investors cannot withdraw their capital from the fund; and hedge funds with share restrictions, which constrain investor redemptions.
Because investors typically lack the specialised knowledge to evaluate a fund manager’s strategy, they tend to assess the manager on the basis of recent past performance. If a long-term strategy to exploit mispricing fails to yield results in the short term, investors may interpret it as evidence of incompetence on the part of the manager. If the fund is open-ended, they are likely to react by refusing to provide more capital or even by withdrawing some or all of it.
As a result, as the research shows, asset managers in open-ended funds tend to ignore mispricing when they think that it will take a long time for asset prices to correct to their fundamental values.
In contrast, managers of closed-end funds, who do not have to worry about investor withdrawals, are shown to take more aggressive positions against mispricing, and particularly to be willing to buy risky ‘fire sale’ stocks, which are trading well below their intrinsic value.
The study further established the relationship between willingness to trade against long-term mispricing and the sensitivity of investment flows to short-term performance by examining funds with a greater number of institutional investors and managers with longer tenure. Because institutional investors are more sophisticated, they do not rely solely on recent performance to evaluate managers; and more senior managers with longer tenure are better able to gain their clients’ trust and keep them in the fund. The research shows that investment flows of open-ended funds with these more sophisticated investors and senior managers are indeed less sensitive to short-term performance.
Fund managers who managed both open-end and closed-end funds did not trade against mispricing in the open-end funds even when they were doing so in the closed-end funds, confirming that it is fund structure rather than managerial ability that lies behind the differing investment strategies.
‘This paper provides empirical evidence of the benefit of closed-end fund structures (and share restrictions) on asset managers’ propensity to trade against mispricing,’ said Dr Kahraman. ‘Open-end structures make it possible for unsophisticated investors to use investment flow to “discipline” fund managers, which means that managers avoid long-term investment strategies that may appear to underperform in the short-term – ironically depriving investors of higher returns overall.’