Now in its tenth year, the Hillsdale Investment Management – CFA Society Toronto Research Award honours quality academic and practitioner-relevant research on investment manager practices. The recipients of this year’s award were chosen from a record number of submissions from across North America – nearly triple the number in 2019. Congratulations go to Paul Calluzzo and Selim Topaloglu of Queen’s University, and Fabio Moneta of the University of Ottawa, for their paper “Complex Instrument Allowance at Mutual Funds.” The winning paper delves into the effects that loosening restrictions on complex instruments have had on fund performance.

The award

Papers are judged for the inherent value their research brings to the investment community. “At its roots, Hillsdale believes in and supports applied investment research and the need to continuously invest in our process for the benefit of our clients. Teaming up with CFA Society Toronto to further such research efforts is a natural for us,” said Harry Marmer, CFA, executive vice president, and partner of Hillsdale Investment Management Inc.

Research into investment manager practices can have profound implications on investing in Canada, and papers are expected to include a consideration of current market conditions, rigorous methodology, and opportunities for future exploration. “High-level published research takes an extraordinary amount of effort and commitment to complete. It is much more difficult than a PowerPoint or just sending an email and definitely more valuable than statements of ‘fact’ that are determined without proper testing,” said Chris Guthrie, CFA, president & CEO, CIO, portfolio manager, and founding partner of Hillsdale Investment Management Inc.

The winning paper

“We decided to focus on complex instruments because there has been a rise in the complexity of mutual funds,” says Fabio Moneta, one of the paper’s authors. “The proportion of funds that are allowed to use derivatives, short sales, leverage, and restricted securities increased from 26 percent in 2000 to 60 percent in 2015. Furthermore, the 2008 global financial crisis brought attention to the use of complex instruments by mutual funds, and regulators were considering rules to limit them. Given that complex instruments are powerful tools impacting risk and return, there is also the concern that managers of poorly governed funds may abuse them.

“This has created debate among practitioners and academics about whether the use of these instruments is harming investors and whether the current regulations are adequate. We felt it was important to contribute to this debate,” he said.

The verdict

Calluzzo, Topalogu, and Moneta found that the allowance of complex instruments was associated with lower performance and higher risk-taking, backing up concerns that already raised by practitioners and regulators. Their research also suggests market downturns and poor monitoring can magnify the adverse impact that complex instruments may have on fund performance.

The three researchers made the following observations:

• The positive returns associated to allowance in up markets do not compensate for fund losses in down markets, as the absolute value of the excess returns in the former (1.27%) is much lower than those in the latter (-5.24%).
• Among the three categories of complex instruments analyzed (derivatives, leverage, and illiquid assets), leverage and derivatives allowance were associated with higher fund risk based on standard deviation and beta exposure. In terms of idiosyncratic volatility, leverage was associated to higher fund risk but derivatives allowance was not because it included stock index futures. The researchers did not find a relationship between illiquid assets and the three risk measures used.
• There is a positive association between allowance and monitoring quality based on institutional fund ownership, fund size, and board independence. The researchers also found that strong monitoring may mitigate the adverse impact of complex instrument allowance on fund performance. These findings support the substitution hypothesis, which “implies that well-monitored funds are allowed to use the instruments because the monitoring mechanism will prevent them from abusing the instruments.” However, the researchers acknowledged that allowance and investment restrictions are not perfect substitutes.

Choosing simplicity

The “complex” part of the term “complex instrument” is an apt descriptor, as the intricacies of complex instruments have driven a trend towards increased complexity in the mutual funds industry. Calluzzo, Topalogu, and Moneta described it as “dual-natured with the ability to either lead funds to safety or to the temptation of higher risk.” This potential for higher risk has led the U.S. Securities and Exchange Commission to amend its framework on complex instruments to address investor protection concerns. Overall, the authors suggest that caution should be exercised when allowing mutual funds to use complex instruments, as investors might be better off with choosing simplicity.

Conclusion

Calluzzo, Topalogu, and Moneta hypothesize that stringent restrictions on investing in hedge funds may underpin the bias towards complexity, as indicated by their research results. In other words, investors may believe that being able to access complex strategies produces outperformance, and may not realize the detriments such instruments can have on their portfolios.

“Complex Instrument Allowance at Mutual Funds” by Paul Calluzzo, Selim Topalogu, and Fabio Moneta thoroughly examines the pitfalls of complex instruments allowance in mutual funds, while exploring potential solutions to this issue. And, like past winners of the Hillsdale Investment Management – CFA Society Toronto Research Award, the authors have created a paper that highlights key opportunities and risks for investing in Canada. 

Learn more about the Hillsdale Investment Management – CFA Society Toronto Research Award