Mutual funds that allow investors to buy or sell their shares on a daily basis are an important component of the financial system, providing investment opportunities for investors and providing financing to businesses and governments.
Open-ended mutual funds, as they are called, have grown significantly over the past two decades, with $41 trillion in assets worldwide this year. This represents about one-fifth of non-banking financial sector assets.
These funds can invest in relatively liquid assets such as stocks and government bonds, or in less frequently traded securities such as corporate bonds. However, those who hold less liquid assets present a major potential vulnerability. Investors can sell stocks daily at a price set at the end of each trading session, but fund managers may take several days to sell assets to accommodate these redemptions, especially when financial markets are volatile.
Such a liquidity mismatch can be a big problem for fund managers during exit periods because the price paid to investors may not fully reflect all of the trading costs associated with the assets they sold. Instead, the remaining investors bear these costs, creating an incentive to buy back stocks before others, which can lead to exit pressures if market sentiment weakens.
Pressure from these investor races could force funds to sell assets quickly, driving valuations further down. This, in turn, would amplify the impact of the initial shock and could compromise the stability of the financial system.
Illiquidity and volatility
This is likely the dynamics we saw at play during the market turmoil at the start of the pandemic, as we write in an analytical chapter of the Global Financial Stability Report. Open-end funds were forced to sell assets amid outflows of around 5% of their total net asset value, which exceeded redemptions from the global financial crisis a decade and a half earlier.
As a result, assets such as corporate bonds that were held by open-ended funds with less liquid assets in their portfolios fell more sharply in value than those held by liquid funds. 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. Beyond the Market Turmoil induced by the pandemic, our analysis shows that returns on assets held by funds are generally relatively more volatile than comparable holdings that have less exposure to these funds, especially during times of market stress. For example, if liquidity dries up as it did in March 2020, the volatility of bonds held by these funds could increase by 20%.
This is also of concern to emerging market economies. A decline in the liquidity of funds domiciled in advanced economies can have significant cross-border spillovers and increase the volatility of emerging market corporate bond yields.
Now, the resilience of the open-end fund industry could once again be tested, this time amid rising interest rates and high economic uncertainty. Outflows from open-ended bond funds have increased in recent months, and a sudden negative shock, such as a disorderly tightening in financial conditions, could trigger further outflows and amplify tensions in asset markets.
As IMF Managing Director Kristalina Georgieva said in a speech last year, “Policymakers worked together to make banks safer after the global financial crisis – now we need to do the same for investment funds.” ‘investment”.
How to limit these risks?
As we write in the chapter, the volatility of assets induced by open-end funds can be reduced if the funds pass on the transaction costs to investors who request redemption. For example, a practice known as swing pricing allows funds to adjust their end-of-day price downward when facing exits. This reduces the incentive for investors to redeem before others. This alleviates the exit pressures that funds face in times of crisis and the likelihood of forced asset sales.
But while swing pricing – and similar tools such as anti-dilution levies, which pass transaction costs onto redeemed investors by charging a fee – can help mitigate risks to financial stability, they must be properly calibrated to do it, and it’s not happening right now.
The adjustments funds can make to end-of-day prices, called swing factors, are often capped at insufficient levels, especially during times of market stress. Policy makers should therefore provide guidance on how to calibrate these tools and monitor their implementation.
For funds holding highly illiquid assets, such as real estate, calibrating swing-pricing or similar tools can be difficult even in normal times. In these cases, alternative policies should be considered, such as limiting the frequency of investor redemptions. Such policies may also be suitable for funds based in jurisdictions where swing pricing cannot be implemented for operational reasons.
Policymakers should also consider tighter oversight of liquidity management practices by supervisors and require additional disclosures by open-ended funds to better assess vulnerabilities. Also, encouraging more transactions through central clearinghouses and making bond transactions more transparent could help increase liquidity. These actions would reduce the risks of liquidity asymmetry in open markets.