| Do mutual fund investors have a destabilising influence on the stock market? |
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| Noel O’Halloran investigates the theory supported by economists David Hale and Henry Kaufman,that the influence of the mutual fund industry today has increased the fragility of the financial system. |
Mutual funds are the largest type of financial institution in the US today when measured by assets under management - even larger than commercial banks. The industry accounts for more than one-fifth of all publicly traded equities and shares in these funds now represent a major part of household wealth.
Increasing popularity
Moreover, greater proportions of households now own stocks, in large part because of their investments in mutual funds. Much of this growth has come in households’ retirement assets as developments in pension plans and other tax-preferred retirement accounts have increasingly made it possible for households to control more of their retirement portfolios. The increased popularity of mutual funds however, brings with it increased concerns - namely, could a sharp drop in equity prices trigger a cascade of redemptions by fund investors that could exert further downward pressure on the stock market?
This question is not simply a matter of economic debate since equity mutual fund investors have lost most of their profits since the mid-1990s. Cumulative gains for those who invested on a monthly basis since 1995 are now less than ten per cent and those who bought later are now losing money. Additionally, net flows have been negative in seven of the past eighteen months as against just one-month of outflows in the previous ten years.
The 1990s bull market in stocks not only encouraged investment in mutual funds but also encouraged these funds to lower their liquidity ratios to historically low levels. Consequently, a collapse in new sales combined with a surge in redemptions could exacerbate the current market slump. Respected economists David Hale and Henry Kaufman have separately argued that the influence of the mutual fund industry today has increased the fragility of the financial system. This paper addresses whether the actions of mutual fund investors could destabilise the stock market.
Mutual funds and the stock market
The view that mutual funds expose the financial system to increased fragility has grown in concert with the increase in the industry’s assets. This concern is exacerbated by the sharp decline in liquidity with cash-equivalent securities dropping to five per cent of equity fund assets. The decline in ratios might not present problems under normal conditions, but it leaves mutual funds with less protection from major shocks to cash flows.
A doomsday scenario, though unlikely is not difficult to construct. A sharp decline in stock prices may lead to a surge in redemption activity. If mutual fund liquidity is not sufficient to meet the bulk of redemption requests, redemptions will quickly lead to security sales and fund managers may also sell securities ahead of redemptions to firm up liquidity, as occurred in 1987. Funds may initially sell their most-liquid securities and quickly improve their ability to meet increased redemptions in the short-term. This would leave funds with less marketable securities in the event of a further drop in the stock market.
The redemptions arising from the initial drop in stock prices may well cause a further weakening in prices and in turn result in a further round of redemptions. The reduced weighting in more marketable securities combined with a fall in the amount of cash-equivalent assets may induce some funds to draw on lines of credit with banks. Many funds have put these facilities in place to improve their ability to cope with a surge in redemptions. These funds would become more highly leveraged and their net asset values would be more sensitive to fluctuations in stock prices. The increased leverage of mutual funds in addition to the increased weighting in less marketable securities could motivate investors to redeem in larger amounts than normal. Consequently, investor confidence could be lost relatively quickly. Given the increased importance of equity mutual funds, the subsequent impact on stock prices could potentially be quite severe.
New sales
Equity fund sales soared during the 1990s increasing from $7.6 billion a month at the start of the decade to more than $100 billion a month ten years later or roughly $4 billion every business day. Numerous reasons have been proposed to explain the explosion in sales, most notably ageing demographics and the consequent growth in the importance of the retirement market.
The growth in new fund sales through the mid- to late-1990s along with the recent decline however, suggests a strong correlation between new sales and stock market returns (see table 1).
The strong correlation between the level of new sales and stock market returns suggests that a positive-feedback process may exist whereby stock market returns cause the new sales at the same time that the new sales cause stock market returns. The correlation between new sales and the level of the S&P 500 using a simple quadratic regression is 0.86. Although this does not determine cause and effect it does mean that a weak stock market may depress the level of new sales levels and ultimately remove an important driver of stock market returns.
Liquidity
Mutual funds are obliged to repurchase shares in any quantity offered, typically at the net asset value of the fund on the day of the redemption request. Mutual funds consequently hold a portion of their assets in highly liquid form, usually cash and treasury securities. This enables them to bridge the settlement period until liquidity is replenished through security sales. The liquidity ratio declined through the 1990s from a high of almost 13 per cent in 1990 to a record low of 4 per cent in March 2000. Liquidity currently stands at just 4.6 per cent of assets, three percentage points below the 1990s average (see table 2).
The decline in liquidity can be attributed to several factors. In the early 1990s equity funds had high liquidity, as the ‘crash’ of 1987 and the market downturn of 1990 were still a recent memory. The plunge in equity fund ratios after this time coincided with the developing bull market in stocks. Stock market returns exceeded twenty per cent in five consecutive years from 1995 to 1999 - the annual average return during this period was more than 28 per cent.
As the bull market in stocks developed the incentives to buy equities were reinforced by a decline in the volatility of stocks. In the early-1990s volatility was relatively high and the recent history gave no impression that this was about to change. However, during the 1990s, the volatility of common stocks dropped significantly relative to the volatility of bond returns.
Other factors that may have contributed to the decline in liquidity ratios at equity funds are the reduction in settlement periods as well all as the growth of lines of credit with banks. The settlement period for US stocks declined from five to three days in 1995 and has since been reduced to just two days. This change meant that funds required less cash to bridge the gap between redemptions and receipts from the sale of stock. Finally, the growth of lines of credit with banks has allowed lower holdings of cash-equivalent assets. This facility was rarely available before October 1987. This allowed fund managers to shift their portfolios from low-yield liquid assets to higher return but more volatile securities.
The increasing competitive nature of the industry poses a serious question to fund managers in a world of low nominal returns going forward. Although current liquidity ratios appear to be too low in the context of increasing risk aversion, it will be difficult for fund managers to raise the level of liquidity to more appropriate levels without sacrificing some return. The cost to performance is easier to justify when equity returns are strong but not so when nominal returns are relatively pedestrian by historic standards.
Although several factors have influenced the level of cash-equivalent securities at equity funds, ultimately stock market performance appears to be responsible for most of the decline in liquidity ratios in recent years. Indeed, as stock prices rose and expected returns fell, as given by the prospective earnings yield the liquidity ratio of equity funds also declined. The close relationship between the prospective earnings yield and the liquidity ratio suggest that fund managers react to past performance rather than anticipate future performance. Declines in liquidity may have been encouraged by the increase in competitive pressures as the number of funds has grown and as investors became increasingly aware of, and sensitive to, rates of return.
Redemptions
Mutual funds have rarely experienced a significant threat from massive redemptions. During the 1970s, two severe recessions and dismal returns on stocks plagued the financial markets. Mutual funds faced a chronic net outflow of money as shareholders responded to the poor performance. However, while this net outflow triggered a downturn in the industry, it did not produce significant signs of financial stress beyond those associated with the macroeconomic climate. Even during the stock market crash of 1987, industry net outflows were small relative to cash equivalents on hand, and only a handful of funds showed signs of serious stress.
This stability is often attributed to a benign shareholder profile. The typical mutual fund investor is middle-aged, married and saving for retirement. More specifically, the typical mutual fund investor is 46 years of age, with median household income of $62,100, median household financial assets of $100,000 and household mutual fund assets of $40,000. Individuals in the primary income-earning years from age 35 to 64 head more than two-thirds of households with mutual fund holdings. Less than 20 per cent of shareholders are retired from their primary occupations.
In addition, the rise in mutual funds as a vehicle for achieving retirement objectives, through IRAs, 401(k) plans and other defined-contribution pension plans, is said to create a solid asset base with long-term objectives, money that is unlikely to move in response to short-run market fluctuations. It is often noted that only under exceptional circumstances can this money exit the retirement fund plan without significant penalties. However, money can be easily switched between money market, bond and equity funds within the same plan without penalties or tax consequences, and this switching has become easier over time. Additionally, today’s employee can get daily pricing on his 401(k) plan and switch between several funds at the drop of a phone call. Consequently, one wonders why the mutual fund assets held by the retirement investors should be any less responsive to market fluctuations than the money held by the average investor.
There is little evidence to support the notion that the shareholder base of mutual funds is stable and has become increasingly so with the growth of the retirement market. Far from being passive investors the evidence suggests that mutual fund shareholders are reasonably active. The monthly redemption rate has averaged 1.6 per cent of assets since the mid-1980s. This means that equity fund investors turn over their fund holdings once every five years. Furthermore, redemption rates have increased in recent years despite the growing influence of the retirement market. The monthly redemption rate has increased from 1.4 per cent of assets in the early- to mid-1990s to more than 2 per cent over the past four years. Thus, redemption activity in recent years has been 50 per cent greater than the early- to mid-1990s (see table 3).
A more important influence on redemption activity is that mutual fund shareholders appear unwilling to realise losses and are therefore likely to delay sales until prices have recovered. This is confirmed by the historical experience - the rate of redemption activity appears to have a strong positive relationship with the direction of stock prices. In other words, higher stock prices leads to higher redemptions and visa versa. This behaviour is consistent with prospect theory, the leading model of decision-making under uncertainty. Prospect theory predicts that investors are ‘loss averse’ and that they will prefer a gamble - holding on to securities, to a sure loss. |
Noel O’Halloran, Chief Investment Officer, KBC Asset Management.
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| Article appeared in the October 2002 issue.
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