NAV inflation and impact on performance in China

• DOI: http://doi.org/10.1111/eufm.12207
• Author: Mark Shackleton,Jiali Yan,Yaqiong Yao
• Published date: 01 January 2020
• Date: 01 January 2020

DOI: 10.1111/eufm.12207

ORIGINAL ARTICLE

NAV inflation and impact on performance in China

Mark Shackleton

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Jiali Yan

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Yaqiong Yao

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1

Department of Accounting and Finance,

Lancaster University Management

School, Lancaster LA1 4YX, UK

Emails: m.shackleton@lancaster.ac.uk;

j.yan@lancaster.ac.uk;

yaqiong.yao@lancaster.ac.uk

2

School of Finance, Shanghai University

of International Business and Economics,

Shanghai 201620, China

Email: yaoyaqiong@suibe.edu.cn

Abstract

Our study is among the first to examine the net asset value

(NAV) inflation practices of fund managers in China,

finding that equity funds bolster their portfolios at quarter-

end and especially year-end. In support of the NAV inflation

hypothesis in China, we further document the following: (1)

NAV inflation is more profound for the worst-performing

fund managers; and (2) the stocks in which fund managers

hold larger stakes exhibit a more marked pattern of price

inflation around quarter- and year-ends than do other stocks.

We also find that closed-end funds in China engage in NAV

inflation at quarter- and year-ends.

KEYWORDS

Chinese market, closed-end funds, mutual funds, NAV inflation

JEL CLASSIFICATION

G11, G12, G23

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INTRODUCTION

Previous studies have highlighted a potential agency problem in the mutual fund industry: managers

could manipulate quarter- and year-end stock prices by excessively purchasing stocks they already

hold to bolster fund performance. This practice is commonly referred to as net asset value (NAV)

We thank John A. Doukas (the Editor), an associate editor, and two anonymous referees for their comments, which

significantly improved the paper. Our gratitude extends to Stephen Brown, Bing Han, William Pouliot, Russ Wermers, and

the participants at the 2016 Portsmouth–Fordham Conference on Banking & Finance, the IFABS Asia 2017 Ningbo China

Conference, and the INFINITI Conference in International Finance 2017 for their useful comments, and to Jeanne

Bovenberg for excellent editorial assistance. We especially thank Jiaguo (George) Wang for intensive discussions. Part of

the paper was completed while Yaqiong Yao was visiting New York University's Stern School of Business in the spring of

2015 and Shanghai University of International Business and Economics in September 2015 and December 2017.

Eur Financ Manag. 2019;1–25. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons, Ltd.

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118 © 2019 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2020;26:118–142.

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inflation, marking up, or ‘tape painting.’The financial press, rating institutions, and regulators pay

disproportionately high attention to funds’quarterly and annual performance, which could link to the

practice of NAV inflation at quarter- and year-ends. Fund managers could aggressively buy stocks in

their portfolios, effectively ‘borrowing’from future performance to push up current returns.

Consequently, funds have abnormally high returns at quarter-ends, followed by return reversals at the

beginning of the subsequent months.

This trading behavior could have detrimental impacts on the two fundamental aspects of financial

markets: market liquidity and pricing accuracy (Kyle & Viswanathan, 2008). There has been mounting

evidence of NAV inflation trades of mutual funds in the United States (Carhart, Kaniel, Musto, & Reed,

2002). Subsequent studies provide supportive evidence for hedge funds in the United States (Agarwal,

Daniel, & Naik, 2011) and for mutual funds in Australia (Gallagher, Gardner, & Swan, 2009). Most of

the studies focus on developed markets but ignore one of the most important emerging countries,

China, which has the second largest stock market in the world.

Compared with those well-developed markets, the Chinese market has a short history and contends

with incomplete regulation, opaque information disclosure, and weak legal enforcement.

1

The

institutional environment is relatively underdeveloped in both the Chinese financial markets and

external corporate governance mechanisms, since shareholder activism is nearly nonexistent (Jiang,

Rao, & Yue, 2015). Meanwhile, the legal protection of minority shareholders is especially weak

(Allen, Qian, & Qian, 2005). Compared with the US Securities and Exchange Commission (SEC), the

China Securities Regulatory Commission (CSRC) is weak in terms of impacting policy, focusing

instead on maintaining the stability of national economic growth.

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It is critical to understand the

behavior of fund managers in China and the potential impacts on fund performance. Naturally, this

makes the Chinese market an ideal testing ground for comparing NAV inflation behavior in an

emerging and fast-growing market to that in developed markets. How different in this respect, if at all,

is China from developed markets?

Our study is among the first to examine NAV inflation behavior in China and to explore its potential

impact on fund performance in the Chinese mutual fund market. We find that fund managers in China

inflate their end-of-quarter and particularly end-of-year NAVs to boost their returns in the current

period, leading to return reversals at the turn of the quarter. Further, the analysis shows that, on average,

fund returns are much higher during the final two trading days at quarter-end than they are during the

first two trading days of the following quarter, especially for the fourth quarter (i.e., year-end). In

China, a fund's year-based performance draws high attention from the media, rating institutions, and

scholars. Managers’annual compensation packages are partially determined by their ranking among

their peers at the end of the calendar year.

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It is possible that such year-end ranking incentives lead to

especially strong NAV inflation at year-end.

Using the market as a benchmark, we find that the adjusted NAVs of the value-weighted (VW)

portfolio are marked up by an average of 23 basis points at quarter-end, a markup that is considerably

larger than that documented in the US market (Carhart et al., 2002) and half the magnitude documented

in the Australian market (Gallagher et al., 2009). We further show that these patterns are not driven by

exposure to common factors. Specifically, we investigate the behavior of funds by examining their

1

See Cheung, Jing, Lu, Rau, and Stouraitis (2009), Cheung, Rau, and Stouraitis (2006), Chi (2016), and Gao, Yan, Yang,

and Zhao (2016).

2

See the report by Citi Securities and Fund Services in 2012, at http://www.citibank.com/transactionservices/home/

about_us/articles/docs/china_asset.pdf

3

See the popular fund-ranking website in China: http://cn.morningstar.com/main/default.aspx

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