Investment funds that hold illiquid, hard-to-sell assets and that calculate their net asset value on a daily basis can trigger volatility and add to the impact of shocks in financial markets, especially in turbulent times, the International Monetary Fund (IMF) said in a policy note addressed to the financial community.
Investment funds that allow investors to buy or sell their shares on a daily basis are an important part of the financial system, providing investors with investment opportunities and financing companies and governments.
Open-end mutual funds, as they are known, have grown significantly over the past two decades, with 41 trillion dollars in assets globally this year. That is about a fifth of the assets of the non-bank financial sector, according to the IMF.
Liquidity mismatch
These funds can invest in relatively liquid assets such as equities and government bonds, or in less frequently traded securities such as corporate bonds.
“Such liquidity mismatch can be a big problem for fund managers during periods of outflows because the price paid to investors may not fully reflect all trading costs associated with the assets they sold. Instead, the remaining investors bear those costs, creating an incentive for redeeming shares before others do, which may lead to outflow pressures if market sentiment dims,” IMF said in its report.
“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.”
Pandemic
The IMF argues that this is probably the evolution we saw during the market turmoil when the pandemic broke out. Open-end funds were then forced to sell assets when there were 5 per cent outflows from their funds.
Looking beyond the pandemic, IMF said its analysis shows that the returns of assets held by relatively illiquid funds are generally more volatile than comparable holdings that are less exposed to these funds—especially in periods of market stress. “For example, if liquidity dries up the way it did in March 2020, the volatility of bonds held by these funds could increase by 20 percent.”
This is also important for emerging market economies. A drop in liquidity of funds based in established economies can have significant cross-border spillover effects and increase the return volatility of emerging market corporate bonds, the IMF said.
For funds holding very illiquid assets, such as real estate, calibrating swing-pricing or similar tools may be difficult even in normal times. In these cases, alternative policies should be considered, like 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 monitoring of liquidity management practices by supervisors and requiring additional disclosures by open-end funds to better assess vulnerabilities. Furthermore, encouraging more trading through central clearinghouses and making bond trades more transparent could help boost liquidity. These actions would reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress.