Zombie movies typically focus on attempts to destroy the walking dead, rather than trying to rehabilitate them. Fortunately, Wall Street is a kinder place than Hollywood.
Consider zombie funds: virtually defunct portfolios, shuffling around until they are put out of their misery. However, they differ in two ways from traditional zombies: they are heading toward, rather than out of, the grave, and they have a brain, in the form of
The manager need not meekly accept the consequences of poor returns and a lack of assets. He or she can try to cling to life, typically by trying to reinvigorate performance and hoping for a kiss of life from fresh inflows.
A new paper by Jannic Cutura of Goethe University Frankfurt and Gianpaolo Parise and Andreas Schrimpf at the Bank for International Settlements investigates how managers go about raising the dead in the US corporate bond sector.
The choice of fixed income rather than equity as the setting for this study is important because previous work by the University of Pennsylvania’s Itay Goldstein, Michigan State University’s Hao Jiang and Cornell University’s David Ng in 2015 established that bond funds exhibit a different performance/inflow relationship than equity strategies.
In equity sectors, winner funds attract lots of new money but losers rarely suffer disproportionate redemptions and so can keep going. But in fixed income, the opposite is true: investors flee the worst performers but don’t tend to reward top managers with significant extra assets. This means bond managers have far stronger incentives to turn weak performance around as quickly as possible.
Playing the dead man’s hand
So how do these incentives shape bond funds’ actions? Cutura, Parise and Schrimpf looked at a sample of 661 actively managed US corporate bond funds between January 2004 and December 2015, tracking portfolio moves and risk exposure, as judged by their holdings’ credit ratings and liquidity. They defined zombie funds as those in the bottom quintile by risk-adjusted 12-month returns, although their results also held for other categorizations of underperformance.
Their primary finding was that zombie funds took substantially more risk in their portfolios, consistent with a hypothesis they termed ‘gambling for resurrection,’ where managers overweight higher-risk bonds in the hope of a higher reward.
Specifically, zombie managers took on a statistically significant 0.8 percentage points more risk as assessed by credit rating, while those in the top quintile were found to be making their portfolios safer. Measuring risk by bond yields instead, zombie funds raised their allocation to high yield securities by 1.4 percentage points on average, while the best managers did not shift their portfolios significantly.
‘We find this behavior to have direct implications for fund performance,’ the authors reported.
‘Returns of zombie funds become more volatile and more negatively skewed. By contrast, those of star funds become less volatile and more positively skewed.’
However, in a different sense, the move often pays off for the managers of zombie funds. While zombie funds suffered outflows that were 0.9 percentage points higher than average, these redemptions moderated to just 0.6 percentage points above average when the managers’ risk-taking climbed by one standard deviation.
‘This suggests that increasing risk-taking helps to mitigate outflows, thereby increasing the chances of the fund to survive,’ Cutura, Parise and Schrimpf summarized.
‘This behavior appears rational from a fund manager’s perspective. While it may be optimal for investors to increase portfolio liquidity to reduce expected liquidation costs, this strategy would hardly be in the best interest of the fund manager. If the termination of the fund triggers the termination of the fund manager’s contract, the optimal strategy for the fund manager ex ante is increasing risk, even if that occurs at a cost for the investors.
‘This is the case because, in case of liquidation of the fund, investors receive the liquidation value of the assets while the fund manager has a negative payoff – for example, losing his job. Hence, the fund manager has an incentive to keep the fund afloat, even if that decreases the final payoff to the investors.’