In a white paper titled “Liquidity and Flows of U.S. Mutual Funds,” the SEC Division of Economic and Risk Analysis examined the U.S. mutual fund industry with particular attention paid to: (i) fund flows; (ii) the liquidity of fund portfolios; and (iii) the interaction of these characteristics.
The white paper emphasized that liquidity risk management is a primary concern for mutual funds due to: (i) the possibility of so-called asset “fire sales;” (ii) the exacerbation of these sales by how a fund’s net asset value is determined for redeeming investors; and (iii) the significant growth in emerging market, fixed income and alternative strategy mutual funds.
The white paper documented the following general trends in U.S. mutual funds:
- the amount of assets held by U.S. mutual funds (excluding money market mutual funds and exchange traded funds) is increasing rapidly;
- potentially less liquid mutual fund categories have grown substantially over the same period, with alternative strategy funds growing faster than any other category;
- the cash and cash equivalent holdings of mutual funds vary significantly, and the variation in cash holdings within each investment category is larger than the variation between investment categories;
- the volatility of net asset flows exhibits considerable variation between investment categories, and alternative strategy funds face more volatile flows compared to more traditional funds;
- portfolio liquidity levels vary significantly between funds and over time;
- among U.S. equity funds, those that invest in large cap equities and those with greater assets hold more liquid equity portfolios; and
- equity portfolio liquidity decreased for U.S. equity funds during the financial crisis, particularly among those funds that already had relatively low equity portfolio liquidity.
Lofchie Comment: It seems inevitable that the final recommendation of the SEC’s study is that mutual funds should hold a greater share of their assets in “liquid” investments. In response, a quotation and a question.
The quotation is from John Maynard Keynes, The General Theory of Employment, Interest and Money, Chapter 12: “Of the maxims of orthodox finance liquidity, none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” The second sentence of this quotation is the one that poses a particular challenge to the regulators. It is clear that the regulators disfavor regulated banks, broker-dealers and insurance companies taking speculative or illiquid positions. Perhaps this makes sense if one views those institutions as primarily serving a custodial function as holders of the assets of others. However, the regulators also clearly disfavor either private funds or public funds holding illiquid positions. (See, e.g., FSOC Seeks Comment on Notice about Risk to U.S. Financial Stability Caused by Asset Management Products and Activities (with Lofchie Comment) Dec. 18, 2014)).
So who will hold such positions? It’s not going to be individuals in their personal accounts, as individual holdings are a very small share of national assets. Pension plans? Foreign sovereign wealth funds? The bottom line is, society as a whole cannot be liquid: someone has to be willing to bear risk for the long term. It is all very well, but a little too easy, for the regulators to assert that a person or type of entity should not bear liquidity risk. But tell us who should bear it? That is the hard question. Unless it is addressed, it is a bit of a fool’s errand to demand the impossible: that everyone become liquid.