Wednesday, October 29, 2014

Are Mutual Funds Being Haunted by Shadow Banking and Illiquidity?

In the October 2014 edition of the IMF's Global Financial Stability Report, there is a very interesting paragraph buried on page (ix) of the Executive Summary:

"The share of credit instruments held in mutual fund portfolios has been growing, doubling since 2007, and now amounts to 27 percent of global high-yield debt.  At the same time, the fund management industry has become more concentrated. The top 10 global asset management firms now account for more than $19 trillion in assets under management. The combination of asset concentration, extended portfolio positions and valuations, flight-prone investors, and vulnerable liquidity structures have increased the sensitivity of key credit markets, increasing market and liquidity risks. " (my bold)

The IMF is concerned that there is a growing share of illiquid debt instruments in mutual fund portfolios, particularly from the shadow banking system.  In case you were not aware of the shadow banking system, it is a $71 trillion system that operates outside of the normal banking system.  For example, the sector includes hedge funds, private equity funds, pension funds, business development companies and real estate investment funds that lend/grant credit to businesses.  The shadow banking term can also apply to the unregulated activities by regulated banking institutions  Shadow banking grew as a result of the banking regulatory system, a set of regulations that require banks to have minimum capital levels, regulations that do not apply to the shadow banking system.  Estimating the exact size of the global shadow banking system is difficult; the Financial Stability Board (FSB) estimated that the global shadow system peaked at $62 trillion in 2007, declined to $59 trillion during the Great Recession and grew to reach $67 trillion in 2011.  According to the FSB's Global Shadow Banking Monitoring Report for 2013, by the end of 2012, the shadow banking system reached $71 trillion.  By size, this is about half of all banking system assets and 117 percent of global GDP.  Year-over-year growth rates in shadow banking in 2012 ranged from -11 percent in Spain to +42 percent in China.  Here is a pie chart showing the share of global non-bank assets by jurisdiction at the end of 2012 (the last year data is available until the FSB's 2013 report released in November 2014):

The IMF goes on to note that there is growing concern about market liquidity, an issue that is related to the shadow banking system.  This concern about liquidity stems from the desperate search for yield in this near-zero interest rate environment that has resulted in increased inflows into many mutual funds.  Mutual fund managers have been able to satisfy this hunger for yield by issuing debt and buying bonds to and from higher risk clients.   In the United States, mutual funds can invest up to 15 percent of their assets in illiquid securities, an investment vehicle that is not allowed in Europe.  Since 2007, mutual funds, ETFs and households have become the largest owners of United States corporate and foreign bonds, accounting for 30 percent of total holdings.  Here is a graph showing the rising ownership of corporate and foreign bonds by households (in blue):

Here is how much growth has been experienced in assets under management for mutual funds and ETFs, showing the increasing level of United States high yield bonds (in blue):

As we all know, mutual fund holders are generally allowed to redeem their holdings for cash, part of the promise made to investors.  A problem could arise in times of "market stress" (i.e. when central banks exit from unconventional monetary policies or when geopolitical risks increase) when it is impossible for mutual funds to meet the demand for redemptions because the underlying corporate debt assets are not liquid or that the cost of redemption is too high, resulting in a capital loss for the fund.  In simple terms, the redemption terms offered by the investment funds may simply not match the liquidity of the underlying assets.

Here is a bar graph showing how vulnerability to distress in the banking sector has grown for bond mutual funds since 2008 (in dark blue):

Not only is there a problem with debt issued by American corporations, mutual fund allocations of emerging market fixed income products grew from 4 percent in 2002 to 10 percent in 2012 with most of that going to China.  Here is a graph showing how bond allocations have moved to emerging markets over the years since the end of the Great Recession:

This is yet another consequence of the search for a reasonable yield.  Mutual fund managers are concentrating their assets in emerging markets where higher geopolitical risk results in higher yields.

Let's close with this quote from the GFSR:

"Six years after the start of the crisis, the global economic recovery continues to rely heavily on accommodative monetary policies in advanced economies to support demand, encourage corporate investment, and facilitate balance sheet repair. Monetary accommodation remains critical in supporting the economy by encouraging economic risk taking in advanced economies, in the form of increased real spending by households and greater willingness to invest and hire by businesses. However, prolonged monetary ease may also encourage excessive financial risk taking, in the form of increased portfolio allocations to riskier assets and increased willingness to leverage balance sheets. Thus, accommodative monetary policies face a trade-off between the upside economic benefits and the downside financial stability risks. This report finds that although the economic benefits are becoming more evident in some economies, market and liquidity risks have increased to levels that could compromise financial stability if left unaddressed." (my bold)

The search for yield and the resulting investment in illiquid or less liquid higher risk fixed income assets could prove to be troublesome for mutual funds once investors realize that the world's central banks are putting an end to their current monetary policy.  As central banks, particularly the Federal Reserve (the leader of the pack), begin to unwind their positions and allow interest rates to rise, the risks involved in their experiment will begin to see the light of day and some investors will pay a very hefty price.


  1. Lucky for me that I'm invested in equity mutual funds, which according to chart 5 have become less vulnerable to distress.

  2. A great deal of the shadow banking world falls into and overlaps into the grey world of derivatives. There is no single commonly adopted definition of derivative or derivative contract in the European Union. This plays havoc with what and when reporting rules apply. It also highlights divisions in how national regulators view reporting rules for the $693 trillion over-the-counter derivatives market.

    Remember this is only part of a much larger market that includes hundreds of trillions of dollars in non-reported agreements and private contracts. Everyone paying attention knows that the size of the derivatives market is 20 times larger than the global economy. The article below explores some of its ins and outs of derivatives and why they could collapse the economic system.