Fast Flows Boost Risk of Mutual Funds Mimicking Hedge Funds

  • Redemptions harder for alternative funds to predict, SEC says
  • Alternative funds also have big swings in size of withdrawals

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.

SEC Review

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.

Fund Returns

The SEC economists found that 1 in 10 alternative funds had a month when outflows exceeded 10 percent of assets under management. By comparison, 1 in 10 of all mutual funds had a month when outflows exceeded 2.9 percent.

Underscoring how much more vulnerable alternative funds are to large withdrawals, 1 in 100 of them experienced a month when assets fell by 36 percent due to redemptions. Among all mutual funds, 1 in 100 had a month in which assets declined by 14.5 percent.

Investment Company Institute spokeswoman Rachel McTague said the trade group is still reviewing the SEC study. The ICI has disputed claims that mutual funds are susceptible to runs, citing data that shows a monthly outflow of more than 1 percent of industry assets isn’t common.

Alternative funds, a category that includes funds that aim to outperform in bear markets or during periods of rising interest rates, invest in stocks, bonds, asset-backed securities and derivatives. On average, these funds declined 1.3 percent this year, according to data from Morningstar Inc. That compares with a return of 0.77 percent for the benchmark bond index, the Barclays U.S. Aggregate.

BlackRock, JPMorgan

Alternative funds on average hold more of their assets in cash than other types of funds -- 22.9 percent compared with 4.1 percent for mutual funds overall. But alternative funds also have the highest variation in how much cash they hold as a cushion, with a quarter of funds holding less than 3 percent of their assets in cash, the SEC economists found.

Some of the largest alternative funds, including the $31.6 billion BlackRock Strategic Income Opportunities Fund, have attracted more cash than they have lost over the past year.

The $19 billion JPMorgan Strategic Income Opportunities Fund, on the other hand, had more than $7.2 billion of outflows in the past 12 months, a period in which it had investment losses of 0.68 percent with dividends reinvested. The Standard & Poor’s 500 Index returned about 0.47 percent over the same period, with dividends reinvested.

JPMorgan spokeswoman Kristen Chambers declined to comment on the SEC study.

Liquidity Plans

The SEC economists’ analysis influenced the outcome of a rule that the agency proposed Sept. 22. Under the plan, which is out for public comment for 90 days, all mutual funds would have to keep a minimum share of their total assets in cash or cash-like investments that can be sold within three days.

The SEC rule requires funds to consider the frequency of investor withdrawals when setting their liquidity plans. For that reason, alternative funds will probably need a higher minimum cushion of easy-to-sell assets, according to the SEC.

“The study found that alternative strategy mutual funds had cash flows that were significantly more volatile than other strategies,” the SEC wrote in its rule proposal. “These funds may face higher levels of redemption risk.”

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