IMF Survey : Plain Vanilla Investment Funds Can Pose Risks
IMF News, April 8, 2015
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- Published: April 8, 2015
Overview
- Publication date: April 8, 2015
- Summary: Even simple investment funds such as mutual funds can pose financial stability risks; regulators need more hands-on supervision, better data, and improved oversight, according to IMF research for the Global Financial Stability Report.
- Context: Asset management industry plays a rising role in the financial system with benefits and risks; debate intensified about risks from less leveraged, “plain-vanilla” investment products such as simple mutual funds and exchange-traded funds investing in bonds and equities.
Size and scope
- The industry manages over $75 trillion assets globally, exceeding 100 percent of world GDP.
- Bond funds have grown significantly, investing in less-liquid assets such as emerging market bonds and high-yield corporate bonds.
- Many funds allow investors to redeem on a daily basis, increasing the mismatch between the liquidity of funds’ assets and liabilities.
- Large redemptions—possibly triggered by an external event, such as a faster-than-anticipated rise in interest rates in the United States—may have widespread market impact, especially if banks are unable or unwilling to step in to provide liquidity.
Key findings: Understanding the risks
- Distinction: Important to distinguish risks introduced by the presence of funds from risks that would exist if investors bought securities directly.
- Market impact: Mutual fund investments affect asset prices, at least in less-liquid markets such as emerging market bonds; mutual fund flows drive price movements in these markets.
- Concentration effects: Prices of assets that are held in a concentrated manner by funds drop more sharply during periods of market nervousness.
- Redemption/run risk:
- Easy redemption options offered by funds can exacerbate the risk of a run by investors wanting their money all at once, compared to investors holding assets directly.
- Some funds have asset-valuation and share-pricing practices that provide a “first-mover” advantage to investors—investors redeeming earlier than others can recover more money.
- Mitigants: “Riskier” funds—those investing in illiquid assets and more vulnerable to runs—protect themselves by holding more liquid assets and charging higher redemption fees.
- Redemption fees are indeed effective in mitigating redemption pressures during stress periods.
- Incentive and herding problems:
- Delegation of day-to-day portfolio management introduces incentive problems between end investors and portfolio managers.
- Asset managers may engage in herding—trading in the same direction as their peers.
- Measures of herding behavior have risen in the past few years, possibly because of a generalized search for yield in a low-interest environment that drove funds to invest in similar assets.
- Size versus asset composition:
- Unlike banks, larger funds and funds belonging to larger asset management companies do not necessarily contribute more to systemic risk.
- The nature of the assets they invest in appears to be relatively more important than size for systemic risk considerations.
Policy recommendations and supervision
- Shift focus: Oversight currently focuses on investor protection and disclosure; regulators conduct little monitoring in most countries. Securities regulators should shift to a more hands-on supervisory approach with better data, risk indicators, and analysis, including stress testing.
- Macroprudential approach: Policymakers and regulators should adopt a macroprudential approach to assess the impact of the industry as a whole on financial system stability.
- Re-assess tools: Supervisors and regulators need to re-assess the role and adequacy of existing risk management tools.
- Reduce run incentives:
- Regulators should find ways to reduce the incentive for investors to withdraw their money when they see others exiting.
- Possible measures: well-designed redemption fees that do not hurt investors overall (for example if the revenue accrues to the fund’s net asset value).
- Fund share pricing should be set so that exiting investors do not pass on the cost of liquidity to remaining ones.
- Establish global standards: Establishing global standards on how to monitor and supervise the industry is essential.
Additional note
- The IMF will release further work from the Global Financial Stability Report on April 15.
IMF Survey : Plain Vanilla Investment Funds Can Pose Risks — April 8, 2015 (International Monetary Fund)