Do Hedge Funds Frontrun Mutual Funds?
Are Mutual Funds Sitting Ducks?
- S. Shive and H. Yun
- A version of the paper can be found here.
- Want a summary of academic papers with alpha? Check out our Academic Research Recap Category!
We find that patient traders profit from the predictable, flow-induced trades of mutual funds. In anticipation of a 1%-of-volume change in mutual fund flows into a stock next quarter, the institutions in the same 13F category as hedge funds trade 0.31-0.45% of volume in the current quarter. A third of the trading is associated with the subset of 504 identified hedge funds. The effect is stronger when quarterly mutual fund portfolio disclosure is required and among hedge funds with more patient capital. A one standard deviation higher measure of anticipatory trading by a hedge fund is associated with a 0.9% higher annualized four-factor alpha. A one standard deviation higher measure of anticipation of a mutual fund’s trades by institutions is associated with a 0.07-0.15% lower annualized four-factor alpha. The effect is stronger for more constrained mutual funds.
The authors claim the following result:
Using past work as a guide, our prediction model uses lagged ﬂows and mutual fund returns as predictors and the fact that mutual funds tend to scale their existing portfolios up or down in response to ﬂows. We ﬁnd that in anticipation of a 1% of volume change in mutual ﬂows into a stock, hedge funds put on trades worth 0.18-0.25% of volume. This type of anticipatory trading by hedge funds is stronger in smaller, less liquid stocks…we show that hedge funds proﬁt from this type of trading: a one standard deviation difference in hedge fund beta (with respect to predicted mutual fund ﬂow) is associated with a 0.53% annualized difference in hedge fund excess return.
They first highlight that mutual fund trades become more predictable post-2002–notice how the circles stabilize. This more reliable predictability facilitates exploitation by smart investors.
I’ll spare you the details from Table 3, which highlight the statistics behind the authors claim. Instead, I’ll quote the interpretation of the results from the paper:
The results in the 2003-2010 data are economically as well as statistically signiﬁcant. A 1% of volume diﬀerence in predicted aggregate mutual fund ﬂows into a stock is associated with roughly a 0.00344*0.01 = 0.0000344 proportion of quarterly volume traded by each institution in the prior quarter. Multiplying this by the average number of funds trading each stock in each quarter, 52, yields 0.18% of quarterly volume on average per stock. Summing the institutional trades by stock removes some noise, as shown in the last column of Table 3, Panel A. A 1% of volume diﬀerence in predicted aggregate mutual fund ﬂows is associated with a 0.01*0.255=0.00255 or 0.25% of volume in anticipatory trading by institutions.
An interesting attempt at identifying if “smart” money exploits the predictability of mutual fund flows. I’m skeptical of the results because of the empirical challenges associated with the question the authors are trying to address. That said, I think this is a commendable attempt at addressing an interesting question.***
Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.***
If you liked this post, don't forget to subscribe to our blog.