A Reason to Consider Exchange Traded Funds?

by | Jun 24, 2016 | Asset Management, News

This week mutual fund investors may have been handed a reason to consider exchange traded funds. This may be especially true regarding bond mutual funds and bond exchange traded funds (ETF’s).

The Financial Stability Board (FSB) this week suggested mutual funds should have the ability to lock up investor’s funds — or charge shareholders for withdrawals if they urgently need cash to ride out a crisis.

Our opinion: Mutual funds are designed with individual investors in mind. If individual investors are working with an advisor and “urgently need cash” the advisor has not done their job. Or there has been some severe miscommunication with clients about their own needs for liquidity.

Late in 2015, the Third Avenue distressed debt fund blocked investor withdrawals. Their decision to block withdrawals spurred a rout among funds in the high-yield area. Yet (at first glance), this appears to be the practice the FSB wants to encourage going forward. We’ll remind readers the Third Avenue fund was a distressed debt fund and built more like a hedge fund, not a typical high-yield fund. Nevertheless, as the news broke, the panic began and quickly spread elsewhere.

The FSB was created in 2009, in the wake of the financial crisis. Their reason behind this decision surprised us: the FSB cited the importance of mutual funds as providers of credit to large companies. The FSB feels this role has grown in recent years as global banks have withdrawn from their traditional role as buyers and sellers of debt.

But the role of a mutual fund is to provide a diversified investment approach for individuals. We do not recall seeing mutual funds standing in as a “buyer of last resort” or to stand in as a “market-maker” or “specialist-type” position to provide liquidity or equilibrium to markets.

We surmise the possible reason behind the FSB’s suggestion is based on an ever-circulating theme. That theme is bond mutual funds (as well as bond ETF’s) have acquired illiquid assets which might be difficult to sell in the future. In fact, the FSB suggested “stress-testing” funds and adding additional restrictions/limitations on holding illiquid securities.

Liquidity (or lack of liquidity) is often factored into a price of a fixed income investment. It’s been said bonds trade “by appointment.” Meaning, bonds are often not as liquid as stocks.

Additionally, many investors own bonds to act as a “buffer” in their account. That is, bonds could act in a way to reduce some volatility from stocks. Then why would an investor look to get completely out of a bond fund (or bond ETF) — especially in the middle of a crisis?

We won’t begin to guess what the outcome of this suggestion will be. Perhaps the proposal will frighten investors, or perhaps the proposal will do more to instill fear there’s something more sinister at work. Or maybe it will become a widely accepted practice.

We can’t predict. For more information, check out the article in the Wall Street Journal (subscription required): http://www.wsj.com/articles/global-regulators-push-new-crisis-prevention-arsenal-oversight-for-mutual-funds-1466611202