Affiliated funds of mutual funds (AFoMFs) are mutual funds that invest only in other funds within the same mutual fund family. AFoMFs have become increasingly popular in recent years after being virtually nonexistent in the 1990s. Drawing on the rationale for the existence of internal capital markets within conglomerates that is well documented in the corporate finance literature, the authors explain that AFoMFs create an internal capital market for their fund families by providing an insurance pool for those funds susceptible to temporary liquidity shocks.

A mutual fund may experience a temporary liquidity shock if there is an unexpected surge in redemptions (withdrawals). In the absence of an internal capital market, such redemptions can lead to fund losses caused by fund assets being sold at fire-sale prices. The authors document that inflows to other family funds from AFoMFs are significantly higher for funds experiencing larger outflows. This finding suggests that fund families use AFoMFs to provide insurance—effectively, an internal capital market—to ordinary family funds that are facing liquidity shortfalls. In short, the insurance pool would allow these distressed funds to avoid costly liquidity-driven trades.

The authors show that disproportionate liquidity provision in these distressed funds has an adverse impact on AFoMF performance—a cost ultimately borne by AFoMF shareholders. But the calculated benefit of these investments in liquidity-constrained family funds seems to outweigh the performance drag, and so the cross-subsidy appears rational for the overall fund complex.

Data on AFoMFs are gathered from Morningstar and CRSP for the October 2002–January 2008 sample period. The authors examine total fund flows of mutual funds affiliated with AFoMFs by decomposing total fund flows into AFoMF flow and non-AFoMF (outside) investor flow. They then sort the mutual funds into deciles according to fund flows from outside investors; the lowest decile contains funds experiencing the highest outflows from outside investors (the lowest-decile funds are classified as distressed) and the highest decile contains funds experiencing the highest inflows from outside investors.

In general, there is a positive correlation between fund flows of AFoMFs and those of outside investors. That is, there is a near-monotonic increase in fund flows from AFoMFs, starting with the second decile and continuing through the highest decile. Interestingly, across all deciles, the lowest decile is composed of the group of mutual funds with the greatest inflows from AFoMFs. Specifically, the authors document that nearly one-third of the outflows to outside investors in these low-decile distressed funds are offset by the high inflows from AFoMFs. In addition, AFoMFs appear to initiate a disproportionate number of new positions in these distressed funds.

The authors document these findings as evidence that the high inflows from AFoMFs help to mitigate liquidity deprivations in these distressed funds. They perform a battery of tests to confirm that the statistically negative relationship between AFoMF flows and outside investor flows for funds in the lowest decile is not spurious and that the AFoMFs are purposely cross-subsidizing liquidity-constrained affiliated funds.

This research is interesting and provides compelling evidence of cross-subsidization of mutual funds within mutual fund families over the time period reviewed. These findings add to the existing literature on the lack of transparency in the mutual fund and ETF industries as it relates to the unobservable actions taken by mutual funds and ETFs—for example, window dressing and securities lending activities.