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NY Fed Economists: Unlevered Funds Subject to Run Risk

A new blog post from economists at the New York Federal Reserve challenges the “conventional wisdom” that “an open-ended investment fund that has a floating net asset value (NAV) and no leverage will never experience a run and hence never have to fire-sell assets.” According to the post, funds are vulnerable to runs because of the “first mover advantage,” or the idea that investors withdrawing from a fund first impose costs on those investors that remain in the fund and thus benefit from being the first to withdraw.

The authors point to a recent study showing that the first mover advantage is amplified in funds holding corporate bonds, whereas the effect is minimized in funds that hold highly liquid treasury securities. The post suggests that the price impact of fire sales also impact investors who choose to remain in the fund because they suffer mark-to-market-based losses and may need to rebalance portfolios as a result, causing further rounds of liquidations and creating implications for the entire financial system.

In light of the potential systemic implications of run risk on mutual fund shareholders and other investors, the authors question whether asset managers or certain of their activities should be designated as systemically important.  To answer this question, the post suggests a “macroprudential stress test” in which the authors “postulate a hypothetical scenario that places substantial strain on the financial system and then trace its consequences.” The authors choose to test the effect of “a permanent, unexpected parallel shift of the yield curve of 100 basis points, holding stock returns constant.” The authors predict that this scenario would result in aggregate spillover losses to the financial system of 22 cents for each dollar of initial losses experienced by bond mutual funds had the yield curve shift occurred in the first quarter of 2015.

The post also notes that the amount of spillover losses have grown over time. Had the shift occurred in the first quarter of 2005, the spillover losses would have amounted to 9 cents per dollar of initial losses. The post argues that the increased estimated secondary losses in 2015 as compared to 2009 are a result of the growth of bond funds during that period, but also due to an increase in mutual fund flow sensitivity to fund performance and an increase in the concentration of illiquid assets in funds with high flow sensitivity.  The authors conclude that the results of the test show that “mutual funds can, in fact, be subject to a “run”—despite the fact that they have no significant leverage and a floating NAV. In addition, the test shows that such a run can produce significant negative spillovers in asset markets through forced liquidations.”