Open-end funds have grown significantly over the past two decades and now manage around $41 trillion in assets globally. And the risks they pose to the global economy are growing, says the IMF.
A new report from the International Monetary Fund underscores the dangers that so-called open-end (or open-ended) funds could pose to the global financial system, including potentially tightening financial conditions and exacerbating market volatility during times of heightened stress. Open-end mutual funds are investment vehicles that use pooled assets and are always open to investment. In other words, investors can take out part or all of their money any day of the week.
A $41 Trillion Market
These funds have grown significantly over the past two decades. Many mutual funds, exchange-traded funds and hedge funds are open-ended. According to the IMF, open-end funds now manage around $41 trillion in assets globally — equivalent to roughly one-fifth of the non-bank financial sector’s holdings. As Investopedia notes, they “are more common than their counterpart, closed-end funds, and are the bulwark of the investment options in company-sponsored retirement plans, such as a 401(k).”
The region of the world with the highest concentration of open-end mutual funds is Europe, which is already in a world of (largely self-inflicted) economic pain. According to Statista, the old continent was home to 59,000 such funds at the end of 2021, compared to 33,000 in the Americas, 38,000 in the Asia Pacific region and 1,710 in Africa.
As the IMF report notes, open-end funds play a large role in the financial system, “offering investment opportunities to investors and provide financing to companies and governments.” But they can become a serious problem when the assets they hold are not nearly as liquid as the daily redemptions they offer to their investors.
When large numbers of investors decide to redeem their funds en masse, such as during a financial crisis, those funds have no choice but to sell assets in the portfolio to raise enough money to meet those redemptions. As long as the assets are highly liquid, such as large cap stocks or government bonds, this is normally manageable.
But when the assets in question are high-yield bonds, loans, commercial real estate or large positions of thinly traded small-cap stocks that can take days, weeks or even months to sell, there is a mismatch in liquidity between what the fund offers to its investors (daily liquidity) and what the fund holds (largely illiquid assets). This is a major downside of these types of open-end funds, notes the report.
Such a 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.
First-Mover Advantage
The inevitable result is a mad rush to the doors. Sophisticated investors are usually the first to make the move. When enough investors try to use the so-called “first-mover advantage” by pulling their money out before everyone else does, the open-end mutual fund faces a “run on the fund” and is forced to sell large volumes of illiquid assets to meet redemptions. But the only way to sell them quickly enough is to sell them at ever lower prices. The longer investors stay in the fund, the more they lose.
When this happens on a large enough scale, setting off a feedback loop of accelerating redemptions and falling asset prices, it can end up posing a risk to the financial system itself, warns the IMF paper.
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.
Right now, the pressures are rising as central bank tightening has triggered a surge of outflows from open-end bond funds.
Been Here Before
This is not a new problem, or one that has just suddenly become apparent, such as, say, UK and US pensions funds’ predilection for exotic derivatives. During the global financial crisis many open-end funds were upended by the liquidity mismatch deathtrap. They included a family of bond market funds marketed by the Charles Schwab Corporation as conservative alternatives to money market funds during the lead-up to the Global Financial Crisis. As my former WOLF STREET colleague Wolf Richter noted in a 2019 retrospective, they turned out to be anything but conservative:
The top 10 holdings, which is what investors could see listed, was the usual mix of Treasury securities and investment-grade corporate bonds, and some highly rated corporate paper. Beneath the skin, 45% of the funds’ holdings were mortgage backed securities (MBS), including many backed by subprime mortgages. Most of them were highly rated as well.
But smart investors in Schwab’s conservative-sounding open-end bond mutual fund kept their eyes on the markets. And when the tide turned in the housing market, they started paying attention, and then they saw that people were defaulting on mortgages, as home prices were dropping.
This was the first warning sign. These astute investors sold their shares of the fund back to Schwab and got their money out, after having earned the juicy yields for years. They had the “first-mover advantage” because what came after them turned into a nightmare for slow-poke investors.
As the waves of redemptions intensified and accelerated, Schwab sold off more and more of its liquid assets, until just about all that was left on its balance sheets were MBS. By that time the subprime crisis was in full swing, the mortgage meltdown was all over the media and the value of those MBS was in free fall:
From its $14 billion in assets in 2005, the fund dropped to $13 billion in May 2007, to $6.5 billion in January 2008, to $2.5 billion in March 2008, to $500 million in July 2008, to about $210 million in October 2009, by which time the fund had been shuttered.
As Wolf notes, investors in the funds who didn’t panic first, or at least early enough, ended up losing the lion’s share of their money:
Unlike the prices of stocks or bonds that investors hold outright, bond mutual funds that experience a run cannot recover because the fund is forced to sell the assets, and they’re gone, and when prices of those assets recover, someone else owns them and takes the gain. A run on the fund is a one-way event that is a permanent loss to fund holders.
In the aftermath, lawyers got rich on the ensuing legislation and hedge funds, distressed debt funds and others that bought the distressed MBS for cents on the dollar from the Schwab fund made a killing by selling them at face value to the Fed.
A Particularly British Problem
Today, broad sell-offs are once again rippling across the financial system as central banks hike rates and reverse their asset buying programs in a desperate (and probably vain) bid to tame inflation, which is largely being driven by supply chain factors. The recent mayhem in the UK’s gilt markets has triggered a rapid sell-down of higher risk assets by heavily levered pension funds as they scramble for cash to meet collateral demands. Those assets include stocks, corporate bonds and shares in open-end property funds, which are a particular British delicacy.
So heavy was the selling that three of the UK’s largest commercial property fund managers — Schroders, which runs the the £2.7 billion UK Real Estate fund; Columbia Threadneedle (£2.3 billion Pooled Property fund), and BlackRock (£3.5 billion UK Property fun) — as well as a smaller fund run by CBRE have admitted that they could not meet the pace of redemptions.
In response, Schroders announced it will make some redemptions originally due on Monday this week as late as July next year. For its part, Columbia Threadneedle said volatile market conditions had forced it to switch from daily to monthly payouts. BlackRock has also imposed new restrictions on withdrawals. All told, around £9 billion of assets have been affected.
This is not the first time that volatile market conditions have forced property fund managers in the UK to gate their funds. In June 2016, in the aftermath of the Brexit vote, six commercial real estate (CRE) funds suspended redemptions. The same happened in March 2020, when the virus crisis was just beginning. At that time, 10 open-end property funds in the UK slammed their doors shut on investors, citing concerns about asset valuation. Between them they managed some £11 billion of assets.
For the moment, it is only institutional investors that have been affected by the newly gated funds. The hope is that it will stay that way and that the funds will once again be able to reopen their doors once the dust settles, as happened in 2016 and 2020.
By contrast, the infamous collapse of Neil Woodford’s £3.7 billion flagship Woodford Equity Income fund (WEI) in June 2019 wiped out the savings of tens of thousands of retail investors and pensioners.
Many of them were taken in by the slick PR and marketing hype. They thought the fund was almost exclusively invested in highly liquid shares, only to discover that around 20% of the assets were actually small-cap stocks, some of which were listed on Guernsey’s International Stock Exchange, which despite the grandiose name is one of Europe’s smallest — and therefore least liquid — stock exchanges. By that time, it was already too late: the first movers had made their move, prompting WEI to shut its gates in June 2019. And they would never reopen.
Until the day he closed WEI for good, in October 2019, Woodford continued to extract £65,000 in daily management fees from his trapped investors. Today, three years on, the fund hasn’t been fully wound up and the current market turmoil is wiping yet more value off its remaining assets.
The collapse of the fund was described by the FT as the biggest British investment scandal for a decade, and it shattered the confidence and trust of many investors in open-end funds. The Financial Conduct Authority launched an investigation into WEI’s collapse but it appears to be going nowhere fast (quelle surprise!) None of which stopped Neil Woodford from trying — and failing spectacularly — to make a comeback with another fund in 2021.
Another high-profile fund that ended up suspending redemptions for many of its investors is the masterfully dubbed H20 Asset Management, which until March this year was majority owned by French investment bank Natixis, which itself is owned by Groupe BPCE, France’s second largest banking group. Like WEI, H20 had accumulated vast holdings of highly illiquid assets, including unlisted securities linked to the controversial German financier Lars Windhorst. When its most clued up investors began realizing this, they rushed for the doors, causing a run on the fund.
In August 2020, at the height of the virus crisis, H2O suspended redemptions on eight funds containing holdings of highly illiquid asset. For four weeks roughly half of the asset management firm’s entire portfolio of assets — €21.7 billion, according to the company’s website — was under wraps. That was just a year after H20’s CEO Bruno Crastes had declared in a (now hilarious) interview with the Financial Times that H20 would never gate.
Bruno Crastes: “we will never gate!”
Narrator: H2O suspended redemptions on a series of UCITS funds just over a year laterpic.twitter.com/uPdO1m7MY0
— Robert Smith (@BondHack) December 18, 2021
In the case of H20 and WEI, investors believed, perhaps naively, that their seemingly easily accessible funds were invested in highly liquid assets. They were proven to be painfully wrong.
Tide Going Out
While I’m no great fan of Warren Buffet, he was spot on with the observation that “only when the tide goes out do you discover who’s been swimming naked.” And the tide appears to be going out right now.
As credit conditions change markedly, investors are moving their money out of riskier assets such as high-yield corporate bonds and emerging market debt, as the IMF report notes:
“The resilience of the open-end fund sector may again be tested, this time amid rising interest rates and high economic uncertainty. Outflows from open-end bond funds have increased in recent months, and a sudden, adverse shock like a disorderly tightening of financial conditions could trigger further outflows and amplify stress in asset markets.”
Europe-domiciled funds reported €73 billion in net outflows to August, according to Morningstar data, excluding money market funds and funds of funds. Among the hardest hit were US bond group Pimco, Italian fund house Eurizon, UK manager Baillie Gifford, Insight Investment Management and Morgan Stanley Investment Management.
Emerging market bond funds have also suffered $70 billion of outflows so far this year, as investors pivot to the soaring yields available in richer countries, particularly the US. This is exactly what has happened in previous emerging market crises, including Mexico’s Tequila Crisis of 1994-5. As the IMF report warns, if these open-end bond funds begin to suffer similar liquidity issues as they did in March 2020, it could heap even further pressure on already struggling emerging markets.
