Return Smoothing and Loan Fund Flows: Can Investors See Through to Fair Value?

Abstract

Over the past decade loan mutual funds have emerged as major investors in syndicated loans. Unlike other investors in syndicated loans, mutual funds are required to mark their loans to market daily when calculating the funds’ net asset value (NAV). Marking to market is challenging because loans are not traded on a centralized exchange and unlike corporate bonds trades, loan trades lack post trade transparency. Thus, determining the fair value of loans involves potentially greater discretion on the part of fund managers. In this paper we examine whether loan mutual fund managers use their discretion to smooth their reported returns and whether misreported returns affect the relationship between fund flows and performance. Overall, we find that evidence of widespread return smoothing by loan funds managers. We find that institutional investors are less likely to chase the returns of loan funds that engage in aggressive pricing of their holdings.