Academics and regulators posit that mutual funds that engage in significant liquidity transformation can be systemically risky. This is because investors in these funds redeem at the fund’s net-asset-value and compete for a common fund liquidity pool. The argument goes that both of these features can lead to run-like behavior because of strategic complementarity considerations. An alternative, more general explanation is that all investors who hold overlapping portfolios compete for finite asset market liquidity when they decide to sell assets, which can lead to investor behavior that should be observationally similar to that reported for mutual fund investors.
To test this, the authors analyze over the period from 2000 to 2021 a class of investors with overlapping portfolios, those that invest in separately managed accounts. Unlike mutual fund investors, these investors directly own the assets in their portfolios and receive the market price when selling them. Hence, the net-asset-value redemption and common liquidity pool channel present in mutual funds has been turned off for these investors.
The results from estimating standard flow-performance models show concave relationships for investors in overlapping portfolios that contain less liquid assets. Consistent with the main conjecture, the authors find evidence that the sensitivity of outflows to past underperformance increases during periods of market illiquidity and for portfolios that are less liquid. Moreover, such behavior is less accentuated for investors with large account holdings because they more likely take into account the impact of their own decisions to sell.
These results expand our understanding of the financial ecosystem and systemic risk and help design more effective regulations. Furthermore, they suggest that the behavior of investors with overlapping portfolios should serve as the benchmark to assess any systemic risk inherent in the mutual fund structure.
Christof W. Stahel is Senior Economist at Investment Company Institute.
The paper has been presented at the session “Which direction for capital markets in the EU and around the world?” organised by CEPS/ECMI in the context of the 2021 CMVM Annual Conference, held in Lisbon on 5 November.