Mutual funds with illiquid assets pose a risk to the financial system

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

In a blog post titled How illiquid open-end funds can amplify shocks and destabilize asset pricesthe IMF said the less frequently traded areas of the $41,000,000,000 global open-ended industry have “major potential vulnerability,” especially in volatile markets.

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

This, in turn, creates a liquidity asymmetry, with the price not fully reflecting the trading costs associated with selling. As a result, investors remaining in the fund bear the costs that could trigger a new asset rush, particularly “if market sentiment weakens.”

“Pressure from these investor races could force funds to quickly sell assets, further depressing valuations. This, in turn, would amplify the impact of the initial shock and could undermine the stability of the financial system,” the IMF said.

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

“As a result, 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,” he said. declared.

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

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

Conversely, ETFs acted as a price discovery tool in the bond market during the coronavirus sell-off in March 2020. As liquidity disappeared from the underlying market, the unprecedented discounts to the net worth of inventory (NAV) were a representation of the true value of net assets. – hourly prices.

The Fed announced an asset purchase program at the onset of the coronavirus crisis in March 2020 with the aim of restoring the smooth functioning of markets, including $8.56 billion in fixed income ETFs, leading to an increase massive improved liquidity conditions.

The IMF said the open-end fund industry could be challenged again in a period of rising interest rates and high economic uncertainty, noting an increase in outflows of bond funds in recent months.

Underscoring this, high yield bond outflows total $38.8 billion 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 rising rapidly, investors are reducing risk in the fixed income world at a rapid pace. As we’ve been saying for some time now, we’re struggling to see the flows to high-quality, high-yield funds reverse.

The IMF said funds should limit the frequency of redemptions or pass on the cost of the transaction to redeemed investors in a bid to reduce risk, but added that the latter option faced challenges in times of market stress. market.

The body also suggested encouraging more transactions through clearinghouses, making bond transactions more transparent, which could help increase liquidity.

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

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Don F. Davis