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Academics Find Mutual Fund Borrowing Can Lead to Underperformance

A paper from academics at Syracuse University and University of Southern California law schools raises the question: is mutual fund borrowing within regulatory limits irrelevant, beneficial, or harmful for fund investors? The authors conclude that, while mutual funds may borrow in an attempt to improve their performance, borrowing fails to boost average returns and increases the volatility of returns, potentially creating serious problems for investors who need to withdraw their money during down markets. The academics studied annual filings of open-end domestic equity mutual funds covering 17 years from 2000 to 2016. They found that 18 percent of mutual funds borrowed money for leverage within that time. The academics noted that funds that borrow money appear to outperform non-borrowing peers during years when stock returns are high but underperform when returns are low or negative. Over the 17-year period, they found that borrowing funds underperform their non-borrowing peers by 62 basis points per year on a total return basis, while also incurring greater risk. Further, after accommodating for the greater risk taking, borrowing funds underperform by 48 to 72 basis points annually. “Not only do borrowing funds underperform, they also expose investors to greater risk taking (increased volatility), thus imposing an additional cost on investors in borrowing funds.” In contrast, the academics found that funds that deploy derivatives and other financial instruments performed comparably to mutual funds that did not use leverage, before and after adjusting for risk, and with less volatility. The authors argue that “borrowing may present a greater risk than derivatives, which have received more attention than borrowing.”

 
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