Are star funds really shining? Cross-trading and performance shifting in mutual fund families

The majority of financial trades take place in open and highly regulated markets. As an alternative venue, large asset managers sometimes offset the trades of affiliated funds in an internal market, without relying on external facilities or supervision. In this paper, we employ institutional trade-level data to examine such cross-trades. We find that cross-trades used to display a spread of 46 basis points with respect to open market trades before more restrictive regulation was adopted. The introduction of tighter supervision decreased this spread by 59 basis points, bringing the execution price of cross-trades below that of open market trades. We additionally find that cross-trades presented larger deviations from benchmark prices when the exchanged stocks were illiquid and highly volatile, during high financial uncertainty times, and when the asset manager had weak governance, large internal markets, and a strong incentive for reallocating performance. Finally, we provide evidence suggesting that cross-trades are more likely than open-market trades to be executed exactly at the highest or lowest price of the day, consistent with the ex post setting of the price. Our results are consistent with theoretical models of internal capital markets in which the headquarters actively favors its "stars" at the expense of the least valuable units.

JEL classification: G11, G14, G23

Keywords: mutual funds, cross-trading, performance shifting, conflict of interests