No One Really Knows What Open-Ended Funds Will Do
It's summer, political uncertainty is in the air, asset prices are plummeting, and concerns about the ability of open-ended funds to withstand a wave of redemptions are rising. Only it's also the summer of 1962, John F. Kennedy is the U.S. president, and the S&P 500 is seesawing between 69.55 and 54.75.
With much attention focused squarely on the seven U.K. property funds that have now pulled up the gates in the face of post-Brexit referendum redemptions, it's worth revisiting an analogous moment in financial market history when the behavior of open-ended funds was similarly thrust into an unflattering spotlight.
The 1962 Kennedy Slide, when the S&P 500 fell by more than a fifth, is ill-remembered today but offers parallels to the current situation. Back then, market participants fretted about the behavior of an unknown entity in financial markets — open-ended mutual funds that allow big and small investors to pool their money into larger portfolios that offer daily liquidity. Practically unheard of in 1929, during the last big U.S. stock market crash, such funds had raised $23 billion in assets by the spring of 1962.
As stock prices seesawed, the worry was that mom and pop would pull their money out, requiring funds to raise cash by liquidating their portfolios at the worst possible time. It was a fear voiced aptly at the time by a stock broker named Charles J. Rolo, and later recounted with equal vigor by financial journalist John Brooks: "The threat of a fund-induced downward spiral, combined with general ignorance as to whether or not one was already in progress, was 'so terrifying that you didn’t even mention the subject,'" he said.
That doomsday scenario never materialized, however. As equity prices dropped, mutual funds made 530,000 in net purchases of shares. When the market recovered that same week and investors were scrambling to buy back into the rally, the funds sold 375,000 shares and made a tidy profit. As Brooks described it: "Far from increasing the market’s fluctuation, the funds actually served as a stabilizing force. Exactly how this unexpectedly benign effect came about remains a matter of debate."
Why this happened has never been satisfactorily explained. While it seems obvious that the funds went bargain-seeking during a panic, it's not entirely clear what allowed them to do so when others were selling.
Brooks posited an explanation and a question that, more than five decades later, seems eerily relevant to our current time: "Taken as a group, the funds proved to be so rich and so conservatively managed that they not only could weather the storm but, by happy inadvertence, could do something to decrease its violence. Whether the same conditions would exist in some future storm was and is another matter."
It is a query worth repeating following the rapid suspension of U.K. property funds and one that has already been raised by Bank of England Chief Economist Andy Haldane, who pondered in 2014 whether some large investors could prove to be a counter-cyclical force in times of market stress or wind up exacerbating it.
While mutual funds counted $23 billion worth of assets in 1962, today they are worth trillions and have, like much of the financial world, expanded their repertoire to encompass less liquid assets including commercial property and, of course, corporate debt. Credit lines and cash buffers have been built up to offset this illiquidity, but the ultimate effect of a massively enlarged and evolved fund industry — and whether it will prove as level-headed as its ancestors — remains poorly understood.