HOW ACTIVE ARE THE INTERNAL MARKETS OF MUTUAL FUND FAMILIES? EVIDENCE FROM THE STOCK PRICE RESPONSE TO S&P 500 INDEX ADDITIONS

Abstract

In general, approximately 27% of stock purchases by mutual funds are systematically offset by sales of other funds affiliated with the same family. I show that, for stocks that are added to the S&P 500 Index, the amount of offsetting trades across funds in the same family increases by 12% around the index addition events. I control for factors that could spuriously create offsetting trades, like the degree of commonality of holdings, the correlations of fund flows, and the number of funds affiliated with the same family. Moreover, perhaps not surprisingly, I show that the funds that are on the buy side during index additions are the more passive funds, and the ones that that are on the sell side are more active, as measured by how much their portfolio holdings normally deviate from what is prescribed by their prospectus benchmark. I also show that, in general, the more passive funds are more likely to get hurt during index additions, as they are more likely to be forced to add the stocks that are becoming part of the index. However, when such passive funds belong to families with a large degree of offsetting transactions, they are likely to perform better compared to their counterparts that belong to families with a low degree of offset. Finally, stocks that are added to the index and which are held by mutual fund families with more offsetting trades have a cumulative abnormal return that is 18% lower than that of stocks with less offsetting trades. I argue that intra-family offsetting trades cause these differences in fund performance and in price impact, based on evidence from a natural experiment – the mutual fund late trading scandal of 2003. Overall, my results suggest that, the existence of active internal markets in the mutual fund industry can have important implications for mutual fund performance, as well as significant asset pricing effects, which can be relevant not only to academics and practitioners, but also to policy makers.