If investment funds maximize assets-under-management and end-investors allocate to outperforming funds, the investment process is compromised. A new theoretical paper suggests that asset managers may prefer portfolios with steady payouts (or steady expected mark-to-market gains) and neglect risks of rare large drawdowns, potentially leading to complete failure of parts of the options market.

Stahmer, Axel(2015), “Fund flows inducing mispricing of risk in competitive financial markets”, European School of Management and Technology, Working Paper 15-04, November 23, 2015

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2696070

The below are excerpts from the paper. Headings, links and cursive text have been added.

Asset managers and inefficiency

“This paper answers the question of how…asset allocations decisions are affected by fund flows from end-investors to asset managers. It provides reasons for misallocation of capital, mispricing of investment opportunities, and the resulting distortions in option implied probabilities.”

“Two assumptions are essential for the model results: Fund managers maximize their assets under management and end-investors allocate their capital to the funds which show the best performance. Both assumptions are established by the related literature…First, fund managers are compensated with a management fee based on their net assets…Consequently, fund managers’ fees are maximized when assets under management are maximized. Second, end-investors’ performance chasing behavior is supported by the literature…Generally, the theoretical and empirical findings suggest that tournament behavior in the mutual fund market is induced by end-investors’ money chasing well-performing mutual funds.”

“Intuitively, asset managers incorporate the flow of funds effect in their investment strategy, which leads to decisions that disregard the risk of large but unlikely negative returns, resulting in market inefficiencies that persist.”

Inefficiencies if the funds industry is small

“The Small Fund Industry model considers a financial market where the fund industry takes exogenous prices as given… That setup is applicable for markets where portfolio decisions delegated to asset managers only account for a small fraction of the overall market and demand has no influence on prices.”

As long as no interaction with outside investors appears, risk-neutral managers take efficient investment decisions…All asset managers choose to invest in NPV [expected net present value] -positive projects and refrain from investing in NPV-negative projects.

“The convex flow of funds relation [investors chasing outperforming funds] leads to capital misallocation in two ways: Over-investment in negative net present value projects, which are likely to attract new ow of funds from outside investors, and underinvestment in positive net present value projects, if these are unlikely to attract new outside capital.

  • Asset managers are inclined to invest in bad projects if the probability of a positive payout is high enough, as a positive investment payout can attract external flow of funds. Hence, in expectation the manager is overcompensated for investing in a negative NPV project by the prospect of receiving new assets under management. This overinvestment stands in contrast to traditional financial theory and is rooted in the incentives induced by the flow of funds from external investors.
  • Asset managers are unable to profit from investment opportunities which depend on rarely occurring events because in most cases these investments result in under-performance until the rare event happens. Moreover, from a capital market point of view, there can exist positive NPV investment projects that are unable to find money from fund managers. If the payout probability is too small, fund managers will decide not to invest, even if they are significantly overcompensated for the risk. The overall result is the inefficient allocation of investment capital for good investment opportunities with low a payout frequency.”

If the new flow of funds are large enough, they dominate the fund managers’ investment decisions to a degree where NPV arguments become irrelevant. Payout frequency becomes the driving factor of asset allocation in the fund management market…Fund managers are willing to take over-proportionally large risks if the negative outcome is unlikely enough.”

“These results deliver a number of interesting implications.

  • First, the loss- given-default or the absolute amount lost when the option does not deliver positive returns becomes nearly irrelevant in markets with delegated portfolio management with large amounts of new money inflows.
  • Second, in the presence of significant new flow of funds the investment rationale of fund managers is no longer based on NPV considerations, but rather on the likelihood that investment opportunities will deliver some positive returns.
  • Third, no fund manager will hedge against risks caused by crises, which occurs very rarely.”

Inefficiencies if the funds industry is large

“The Large Fund Industry model considers a competitive financial market in which prices are determined endogenously…By the end of 2014, mutual funds…managed USD31 trillion of assets…[In this model] the influence on market prices of each individual manager is negligible…[However,] aggregating the investment decision across all asset managers determines the market supply and the market demand for any given price.”

“Without potential flow of outside funds from end-investors… the market price of the investment opportunity leads to zero NPV, which is consistent with classical financial theory. Market participant are indifferent between buying, selling or refraining from trade at the equilibrium price.”

“The incentive to receive new assets under management marginalizes the effect of the NPV and leads to an over-proportionally high demand for options with frequent positive payoffs and an over-proportionally high supply for options with infrequent positive payoffs.”

“No asset manager is willing to engage in an investment which pays off too rarely or to short-sell an investment which pays out too often, as both strategies are unlikely to secure new investments from end-investors.”

“The presence of new flow of funds leads not only to mispricing of investment opportunities but to complete market failure for options with sufficiently low or sufficiently high payout probabilities.”