U.S. regulators fretting that asset managers aren’t prepared for the Federal Reserve’s liftoff or another event that might trigger market turmoil may have found their problem child.
Alternative mutual funds, which mimic the strategies of hedge funds by using leverage and short selling, have outflows that are harder to predict, according to a paper released last week by the U.S. Securities and Exchange Commission. That’s because alternative funds experience larger swings in the size of investor redemptions, with the variation of the typical fund’s flows more than twice as great as that of the broader industry, the agency’s economists found.
Tracking deposits and withdrawals is important, because money managers have to make sure enough of their holdings can be readily turned into cash to meet investor redemptions.
The SEC’s analysis of mutual funds underscores a broader concern that some funds could struggle to meet investor redemptions during periods of market stress. In recent years, the $18 trillion industry has been boosting investments in harder-to-sell assets such as junk bonds and corporate loans. A key worry is that when the Fed raises interest rates for the first time in almost a decade, bond prices will fall and investors will try to exit debt-focused mutual funds all at once.
While investors frequently move in and out of alternative funds, the products are still the fastest growing of all mutual-fund categories, with assets surging to $334 billion in 2014 from $365 million in 2005, the SEC reported. One reason they are popular is that the funds have helped small investors diversify beyond stocks and bonds into strategies once restricted to the wealthy.
But while hedge funds typically limit investors to quarterly and even annual withdrawals, alternative funds must return cash to exiting investors within seven days, and honor redemption requests every day.
Alternative funds have been a focus for the SEC, which for the past year and a half has been reviewing how they manage the potential for large redemptions. In March 2014, then SEC examinations chief Drew Bowden said it’s “fraught with risk” to buy hard-to-value and illiquid securities in funds that have to value assets daily and promise investors easy withdrawal terms.
The SEC’s study of mutual fund liquidity was done by economists Paul Hanouna, Jon Novak, Tim Riley and Christof Stahel, who analyzed data from 1999 through 2014. For alternative funds, which were introduced later, the SEC looked at data from 2005 through 2014.