Here’s some common wisdom on Wall Street: Mutual funds can safely own infrequently traded debt and promise investors easy cash withdrawals as long as the funds have a big pool of cash-like assets.
There’s only one problem: It may not be true.
That’s the premise of Yao Zeng, a doctoral candidate at Harvard University, who explains his view in an unpublished paper. His view is worth exploring because it highlights how fleeting these cash cushions can be and how they can lull investors into a false sense of confidence. In a period of heavy withdrawals, those liquid assets can get used up quickly, leaving any remaining investors in a much worse position.
“Despite optimal liquidity management, mutual funds are not run-free” and may be vulnerable to losses from fire sales of their assets, Zeng writes.
Underlying Zeng’s point is the idea that investors don’t all rush for the exits at the same time without some catalyst. In the case of Third Avenue Management, which decided to close a $788 million distressed-debt mutual fund last week, investors had been steadily pulling out cash after getting fed up with month after month of big losses.
The fund initially sold assets to raise cash, but after a while, its performance didn’t improve and withdrawals continued. By the end, the fund was left with some of the worst, hardest-to-sell assets, giving it the option of either selling its holdings for almost nothing or throwing up some gates, which it’s still trying to do.
While this is an extreme case, it underscores how fickle investors can be in the face of weeks or months of deteriorating sentiment. Such a shift in risk appetite can be caused by anything from the continuing slump in commodities to a rash of corporate defaults to a change in a nation’s economic policies.
Mutual-fund managers face a conundrum when they start receiving heavier-than-usual outflows: They can sell their most-liquid assets or they can deplete their pools of cash in a wager that investors’ mood will improve sooner rather than later. If sentiment doesn’t turn in their favor, they’re stuck trying to rebuild their cash reserves, whether to comply with regulatory demands or to prepare for additional rounds of withdrawals, with an even less desirable pool of bonds available to sell.
There are, of course, other measures that funds often take to protect themselves against fire sales, including having lines of credit with big banks that they can lean on in a pinch.
Zeng points out that the theoretical mechanism of mutual-fund runs is not well understood and is heavily disputed. Third Avenue’s recent debacle shows they are possible. Managers and investors need to understand that a cash cushion may not be the buffer they think it is.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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