Earlier today, The New York Fed’s Liberty Street blog posted a disconcerting article about the risks that open-end funds, such as mutual funds and hedge funds, can experience when high numbers of investors demand their money back at the same time.
The post — Are Asset Managers Vulnerable to Fire Sales? — starts by debunking a myth of ‘conventional wisdom’: That a fund, without leverage or a fixed NAV, won’t experience a run if it is forced to sell assets at fire sale prices. (The theory behind the myth is that the decline in value in the fund’s assets will automatically reduce the fund’s equity in equal measure.)
If this debunked myth of safety sounds a little too theoretical to you, in comparison with the way the real world works, Liberty Street proceeds to unpack the reasons why investors would still demand redemptions under precisely those circumstances.
To quote directly from the post:
“The main reason a fund is vulnerable to runs is the existence of a first mover advantage when investors want to redeem their shares. The first mover advantage stems from the way in which funds pay out redemptions. When investors redeem, their shares are valued at end-of-day floating NAV [Net Asset Value] and paid later in cash. Investors who withdraw earlier impose various costs on investors who withdraw later. The most important is perhaps the cost of selling illiquid assets. “
So the investors who get out first get their shares redeemed at a higher Net Asset Value and are then later paid out in cash. (Or, put the opposite way, those who stick around too long get burned by having their shares redeemed at a lower Net Asset Value.)
Even in the absence of leverage, illiquidity can cost investors dearly. As Liberty Street puts it:
“When facing small redemptions, a fund can use its liquidity buffer to make payouts and avoid liquidation losses, but when redemptions exceed the liquidity buffer, the fund will have to sell assets to pay the investors. For illiquid assets, this is costly, because the fund can only sell at discounted prices. Depending on the size and speed of the redemptions, a forced liquidation of assets can significantly reduce the price at which those assets are sold.”
Liberty street goes on to cite an academic paper that provides real world evidence demonstrating that mutual funds which own corporate bonds are more vulnerable to massive demand for redemptions than equity-only funds during periods of poor performance.
Liberty street sums up the paper like this:
“Because corporate bonds tend to be more illiquid than stocks, the first mover advantage is amplified. Conversely, the authors also show that investors in funds that hold Treasury securities (which are highly liquid bonds) have little redemption sensitivity to performance even though they have the same payout structure as corporate bond funds.”
This lack of liquidity in corporate bonds is caused by differences in the mechanisms by which the securities trade. Corporate bonds are less liquid because they aren’t exchange traded. Unlike stocks, corporate bond trades are executed on trading desks through third parties, known as broker’s brokers, who negotiate the bid / ask spread. There are no market makers to guarantee liquidity in corporate bond trades. During periods of high volatility, precisely the conditions during which large numbers of investors may want to exit a position, bid / ask spreads can widen dramatically. Moreover, the broker’s broker model allows for very little price transparency for those who wish to buy and sell securities. (Some corporate bonds, for example, may not trade at all for extended periods of time.)
All of which ought to make investors more curious about the nature of the funds that they invest in.