The Investment Company Act of 1940 regulates the capital structure of mutual funds in order to restrain their leverage and speculative character. It is often (mistakenly) assumed that the law prohibits open-end mutual funds from borrowing money. This Article (I) analyzes the law governing mutual fund capital structure to reveal when (and to what extent) borrowing is allowed and (ii) examines a novel dataset on mutual fund capital structure that shows borrowing is an unexpectedly common practice.

Using data on all registered investment companies in the U.S. from 1998 to 2013, I find that nearly 8% of open-end mutual funds, and 10% of all mutual funds, borrow money for leverage purposes each year. This figure increases to over 12% of funds when I include non-conventional forms of borrowing. In fact, mutual funds borrow about as often as they employ the most commonly used derivatives. Closed-end funds are more aggressive than open-end funds in their borrowing, often pushing leverage to the regulatory limits. I find that, in addition to borrowing for leverage purposes, mutual funds also borrow on a short-term basis to manage liquidity, via a host of practices: bank lines of credit, overdrafts on custodial accounts, and joint borrowing and lending facilities that allow funds to borrow from other funds. Recent regulatory initiatives (which focus on risks arising from illiquidity and derivatives) overlook the substantial borrowing practices of mutual funds.