Squeeze The World

Can The Fund Management Industry Pose a Serious Threat to the Global Financial System?

Squeeze The World

A recent article published in CNBC highlighted the current attention that the fund industry is receiving from lawmakers. Specifically, since the most recent financial crisis and the superfluous amount of risk taken by some of the largest financial institutions in the world, lawmakers are putting the fund management industry under the microscope to see if they can also be marked with the proverbial “too big to fail” tag.

The article referenced a letter issued by the U.S. Treasury’s Office of Financial Research naming some of the systemic risk that mutual funds could impose on the entire financial system and introducing the possibility of cuffing some of the largest fund companies like the Vanguard Group, Blackrock, and State Street with a Systemically Important Nonbank Financial Institution (SIFI) tag, thus having them fall under additional regulation by the Federal Government. This letter came on the heels of a similar report issued by the Financial Stability Oversight Committee (FSOC) in September of 2013, claiming that mutual redemptions and activities of mutual fund managers “can introduce vulnerabilities that pose, amplify, transmits threats to financial stability.”

It seems plausible to think that extremely heavy “across-the-board” redemptions in some of the largest mutual funds could substantially impact market prices thus further fueling potential margin calls and so forth and so on. It is a scenario that has never happened since the establishment of mutual funds, or at least not in this country. Although there still may be some concern about having a tremendous amount of investor money tied up in one particular mutual fund, we do not believe this should cause an unwarranted amount of concern for our investors. Furthermore, the cost of additional regulation to fund companies will almost always be passed onto investors with really no beneficial reciprocity.

It is first important to understand the facts associated with the original culprits in the “too big to fail” debacle in 2008 and 2009. And much of this understanding can come from the distinction between banks and fund companies. Many can point to a lack of industry oversight as the main reason for the sub-prime mortgage crisis to move from an isolated risk to a world-wide contagion, but most can agree that excessive risk (or leverage) taken by the largest financial institutions was what turned a blip in one segment of the market to one of the biggest overall market downturns we have seen since the Great Depression. In essence, leverage can definitely be a “systematic” risk that could create significant financial instability, as proven by recent history, and the inspiration for current legislation like the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. But leverage is to banking like gravity is to Earth: they are just a fact of life. And with facts of life, additional federal oversight is warranted.

In contrast, mutual funds and even exchange-traded funds are not inevitably tied to leverage. In a research report done by the Vanguard Group, the largest mutual fund company in the world, their team identifies 3 key issues when comparing the fund management industry to their banking counterparts: the distinction between “systematic” (widespread) vs. “idiosyncratic” (limited) risk, mutual fund structure, and history of mutual fund redemptions. Their analysis specifically excluded investment banks, separately managed accounts, hedge funds, and money market funds.

While leverage and the interconnectedness of systemically important companies can lead to widespread risk, most mutual fund redemptions are limited to specific fund families. Since most of the assets that are held in passively managed mutual funds are held by institutions, who have historically shown more discipline than retail investors, the likelihood for heavy redemptions is highly unlikely for the largest mutual fund companies since the majority of their assets are passively managed. There have been zero examples in history showing a widespread redemption in stock and bond funds.

The structure of mutual funds is also a key distinction that must be addressed. The Investment Company Act of 1940, which has regulated the mutual fund industry for the last 75 years, effectively limits the affects of the specific actions taken by mutual fund managers on the overall financial system. This includes the restriction of leveraged activities (short sales, purchase on margin, etc.), stringent liquidity requirements, daily mark-to-market valuation of fund assets, legal separation of fund assets and the management of those assets, and a separate custodian for fund assets (usually a bank). While a typical bank may be leveraged 11-to-1 meaning that there is $1 in actual equity for every $11 in risky assets, fund companies have a 1-to-1 ratio, meaning that there is no leverage. Funds must also hold at least 85% of their assets in liquid securities whereas banks usually hold very illiquid mortgage loans (even if they are securitized). Fund companies also only allow for redemptions based on end of market prices creating no incentive for one shareholder to redeem before another to try to avoid the “run on the bank” effect. Banks, on the other hand, usually hold more illiquid assets thus not being able to redeem depositors’ requests through the sale of assets, effectively creating a “run on the bank,” given the asset-liability mismatch that is not an issue with mutual funds.

Lastly, as the Vanguard Group pointed out, redemptions in mutual funds are driven by investor behavior not the asset managers. This is quite different from “forced sales” which are usually the consequence of margin calls made on institutions that have utilized margin.

All of the same principles apply to Exchange Trade Funds (ETFs). Although they are traded with much more frequency than traditional mutual funds, they fall under the same guidelines in terms of the 1940 Act.

While lawmakers are doing their civil duty in attempting to protect the one’s they are supposed to serve, there may be more bad than good by applying the same regulatory oversight to fund companies as they do to banks. They are two very distinct institutions that require different regulation given their legal structure. Any additional regulation will cost investors; especially those who invest in passively managed mutual funds.