Dangers of Large Mutual Funds

Some of you might remember back to the stock market crash of October 1987, when major indices fell about 25% in one day. There was a lot of finger pointing at the time about the cause, but I remember a number of people saying that a major mutual fund company decided to unload a lot of stocks quickly. That crash of 1987 happened and reversed quickly, partly because stock markets are so big and liquid. But what about other markets, such as high-yield and distressed bonds.

New attention is being drawn to the fact that a few large mutual fund companies control major positions in some asset classes and even in the bonds of some companies. There are several potential concerns. One is that all this mutual fund buying gives a false picture of how liquid and efficient the market is. Another concern is that if these funds suffer large redemptions they’ll have to sell the bonds quickly and at whatever price they can. It could be like the fall of 2008 again. Read the linked article for more.

The chief risk officer of Goldman Sachs, Craig W. Broderick, warned at the I.M.F. meetings last week that the asset management firms that now hold the bulk of these bonds had not yet been tested in terms of how they would react to a market shock.

“Now there is plenty of liquidity,” Mr. Broderick said. “But when things are different, the alternative providers will not be there.”

The term of art for this scenario is a liquidity mismatch, with some going so far as to call it a systemic liquidity mismatch. If, for example, there is a sustained emerging-market crisis and a fund wants to liquidate these bonds to meet redemption demands, the manager will be required to provide cash immediately even though it may take several days to sell the securities in question.