Mutual Funds With Illiquid Assets Pose Risk to Financial System

October 06, 2022

LONDON – The International Monetary Fund (IMF) has warned that open-ended mutual funds which offer exposure to illiquid assets pose a systemic risk to the financial system.

In a blog post titled How Illiquid Open-Ended Funds Can Amplify Shocks and Destabilise Asset Prices, the IMF said the less frequently traded areas of the $41trn global open-ended industry have a “major potential vulnerability”, particularly in volatile markets.

Investors can sell their shares daily at a price given at the end of each trading session, however, fund managers in areas such as corporate bonds, certain emerging markets and property could take several days to trade their assets, the global body said.

This, in turn, creates a liquidity mismatch, with the price not fully reflecting the trading costs associated with the sale. As a result, the remaining investors in the fund bear the costs which could spark a further run-on asset, particularly “if market sentiment dims”.

“Pressures from these investor runs could force funds to sell assets quickly, which would further depress valuations. That, in turn, would amplify the impact of the initial shock and potentially undermine the stability of the financial system,” the IMF said.

It added this was the “likely” dynamic we saw at the start of the market turmoil triggered by the pandemic, where mutual funds were forced to sell assets after experiencing outflows of over 5% of their total net asset value.

“Consequently, assets such as corporate bonds that were held by open-end funds with less-liquid assets in their portfolios fell more sharply in value than those held by liquid funds,” it said.

“Such dislocations posed a serious risk to financial stability, which was addressed only after central banks intervened by purchasing corporate bonds and taking other actions.”

This is not the first time questions have been raised about the mutual fund structure. Following the Neil Woodford debacle in 2019, former Bank of England governor said mutual funds were “built on a lie” due to the liquidity mismatch between the offer of daily trading and the underlying holdings.

Conversely, ETFs acted as a tool of price discovery in the bond market during the coronavirus sell-off in March 2020. As liquidity vanished from the underlying market, the all-time high discounts to net asset value (NAV) were a representation of real-time prices.

The Fed announced an asset purchasing programme at the onset of the coronavirus crisis in March 2020 in a bid to restore the smooth functioning of the markets, including $8.56bn of fixed income ETFs, resulting in a massive improvement in liquidity conditions.

The IMF said the open-ended fund sector might be tested again in a period of rising interest rates and high economic uncertainty, noting a rise in bond fund outflows in recent months.

Highlighting this, high yield bond outflows total $38.8bn so far this year, according to the Bank of America (BoA).

Ioannis Angelakis, credit derivatives strategist at BoA, said: “Outflows are accelerating amid rapidly rising rates volume levels across the globe.

“With ‘risk-free’ rates ascending rapidly, investors reduce risk in fixed income world at a fast pace. As we have been saying for some time now, we struggle to see flows into high-grade and high-yield funds reversing.”

The IMF said funds should limit the frequency of redemptions or pass on the transaction cost to redeeming investors in a bid to curb the risks but added the latter option faces challenges in periods of market stress.

The body also suggested encouraging more trading through clearing houses, making bond trading more transparent, which could help boost liquidity.

 

[Editor’s note: This article originally appeared on ETF Stream]

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