## How Illiquid Open-End Funds Can Amplify Shocks and Destabilize Asset Prices

_IMF Blog, October 4, 2022_

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**Canonical URL:** [How Illiquid Open-End Funds Can Amplify Shocks and Destabilize Asset Prices](https://www.imf.org/en/blogs/articles/2022/10/04/how-illiquid-open-end-funds-can-amplify-shocks-and-destabilize-asset-prices)

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## Bibliographic details
- Authors: Fabio Natalucci, Mahvash S Qureshi, Felix Suntheim
- Published: October 4, 2022

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### Role and scope of open-end investment funds
- Open-end investment funds allow investors to buy or sell their shares daily and have grown to "$41 trillion in assets globally this year."
- These funds represent "about one-fifth of the nonbank financial sector’s holdings."
- Funds may hold liquid assets (stocks, government bonds) or less-frequently-traded securities (corporate bonds); those with less-liquid holdings face a liquidity mismatch because "it may take fund managers several days to sell assets to meet these redemptions."

### Mechanism of amplification and investor incentives
- Daily redemptions priced at end-of-day can fail to reflect full trading costs when assets are hard to sell, shifting costs to remaining investors and creating "an incentive for redeeming shares before others do."
- This incentive can trigger run-like outflows; forced rapid asset sales by funds can "further depress valuations" and "amplify the impact of the initial shock," potentially undermining financial stability.

### Empirical observations and stress scenarios
- During the start of the pandemic, open-end funds experienced outflows "of about 5 percent of their total net asset value," exceeding global financial crisis redemptions a decade and a half earlier.
- Assets such as corporate bonds held by illiquid funds "fell more sharply in value than those held by liquid funds."
- Analysis shows returns of assets held by relatively illiquid funds are generally more volatile than comparable holdings in less-exposed funds—"especially in periods of market stress."
- Scenario 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."
- Cross-border considerations: "A decline in the liquidity of funds domiciled in advanced economies can have significant cross-border spillover effects and increase the return volatility of emerging market corporate bonds."
- Current context (October 2022): rising interest rates and high economic uncertainty have led to increased outflows from open-end bond funds and raise the risk that a "sudden, adverse shock like a disorderly tightening of financial conditions could trigger further outflows and amplify stress in asset markets."

### Policy tools and calibration challenges
- Passing transaction costs to redeeming investors can reduce asset volatility induced by open-end funds.
  - Swing pricing: "allows funds to adjust their end-of-day price downward when facing outflows," reducing first-mover redemption incentives and easing outflow pressures and forced asset sales.
  - Antidilution levies: "pass on transaction costs to redeeming investors by charging a fee."
- Calibration issues:
  - "The adjustments that funds can make to the end-of-day prices—known as swing factors—are often capped at insufficient levels, especially in times of market stress."
  - For very illiquid assets (e.g., real estate) calibrating swing-pricing or similar tools "may be difficult even in normal times."
  - Operational or jurisdictional constraints may prevent implementation of swing pricing.

### Policy recommendations and supervisory actions
- Policymakers should provide guidance on how to calibrate swing pricing and monitor implementation to ensure effectiveness.
- Consider alternative measures for very illiquid funds or where swing pricing is not operationally feasible, such as "limiting the frequency of investor redemptions."
- Increase supervisory monitoring of liquidity management practices and require additional disclosures by open-end funds to better assess vulnerabilities.
- Encourage market structure reforms to boost liquidity, including:
  - More trading through central clearinghouses.
  - Making bond trades more transparent.
- These actions aim to "reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress."

*This blog is based on Chapter 3 of the October 2022 Global Financial Stability Report, “Asset Price Fragility in Times of Stress: The Role of Open-End Investment Funds.”*

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## References

- [Global Financial Stability Report](https://imf.org/en/Publications/GFSR/Issues/2022/10/11/global-financial-stability-report-october-2022)
- [speech](https://www.imf.org/en/News/Articles/2021/09/17/sp081721-financial-stability-priority-boosting-the-resilience-of-investment-funds)

_Source: https://www.imf.org/en/blogs/articles/2022/10/04/how-illiquid-open-end-funds-can-amplify-shocks-and-destabilize-asset-prices_