— Paul Amery's Blog


The UK’s asset management sector is a classic case of market failure. Its services are allocated in a sub-optimal way, while clients are not shifting their resources to achieve better outcomes.

The Financial Conduct Authority’s (FCA’s) interim report on asset management, released earlier today, demonstrates the lack of effective competition via a couple of charts.

The average ongoing charges for actively managed funds have remained static during the last decade, while those for passive (index-tracking) funds have been declining.



How is this possible? After all, it’s passive that has been taking a steadily rising share of the funds market. Assets in index-tracking funds have risen fivefold in the last decade and they now represent 23 percent of the overall market, says the FCA.

On the basis of the increasing competition from the passive sector, you’d expect the active fund operators to be cutting fees to compete. That they haven’t done so at all is an indictment of their business model. And it’s a very short-sighted one, suggestive of senior executives angling for a last fat bonus before the tide turns, and reminiscent of the well-publicised excesses in the banking sector.

The FCA cites a number of reasons why active managers may have been so immune to competition.

First, there are too many intermediaries between savers and fund managers, and many of those advising on the selection of active managers—whether pension fund consultants, fund ratings services or fund supermarkets—overemphasise the importance of past performance. This facilitates a merry-go-round of managers, lucrative for the intermediaries but detrimental for the clients.

The success of consultants’ own manager recommendations may be poorly monitored, while the consultants increasingly risk conflicts of interest, such as when providing fiduciary management services—getting involved in asset allocation, portfolio construction and risk management, traditionally the asset managers’ domain.

Meanwhile, retail clients may either be woefully misinformed about the costs of the products they invest in—according to the FCA, about half of retail investors don’t know they are paying a fee at all—or may be restricted from accessing the lowest-priced funds, either because their financial advisers don’t suggest them, or because their fund supermarkets don’t have them on the menu.

If it may be uncomfortable reading for many active asset managers, the FCA’s report threatens even worse news for the consultants and supermarkets, whose business models are now under close regulatory scrutiny.

But while the FCA report provides substantial evidence that there is cartel-like behaviour amongst active managers, it’s striking how competitive the passive funds business has become (see the sharply falling ongoing charges figure in the second chart above).

We’ve witnessed a wave of competition amongst ETF providers in the last few years, with firms forced to cut fees to compete with the likes of Vanguard, which prices its funds at cost.

There’s also been a substantial automation of passive fund management, with firms seeking to cut out expensive human intermediation and improve their operational efficiency.

The FCA’s survey reminds us of some basic human psychology. Every basis point in fees matters if you’re trying to track an index, while if you’re sold on high future performance you may turn a blind eye to what you pay. This is despite the overwhelming evidence that the costs you incur are the best indicator of what you’ll end up with.

So there will always be some demand for high-octane versions of fund management, with the associated high fees. But for the bulk of the active funds industry, there’s now a version of passive management that threatens to eat their lunch and shave zeros off the annual bonus.

The evidence released today by the FCA suggests that smart beta funds, which aim to deliver better risk-adjusted returns than conventional index trackers by using alternative weightings, are likely to take substantially more market share.

(Disclosure – I’ve done paid writing work in the last year for firms that provide smart beta and index products) 

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US mutual fund manager Third Avenue Funds’ justified its decision on Wednesday to gate redemptions from its Focused Credit Fund (FCF) as follows:

“We believe that, with time, FCF would have been able to realize investment returns in the normal course. Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

Instead, investors remaining in the fund will be placed in a Liquidating Trust and will have to wait for the return of their money until the fund manager can dispose of the assets at what it calls “reasonable prices”. That may take months or more.

US mutual fund investors entering and exiting a fund do so on the basis of the fund’s net asset value (NAV), which is hard to determine in illiquid markets. If exiting investors are able to do so at prices that do not reflect the liquidity of the underlying market, they obtain an unfair advantage over those remaining in the fund, whose interests are diluted.

A central question is unanswered in Third Avenue Funds’ statement. Why not mark down the fund’s NAV until it reflects the price at which its portfolio of junk bonds can be sold?

Marking fund NAVs to the “bid” side of quotes in the portfolio is common practice in a bond fund, since it represents the most conservative approach. A portfolio of assets is realistically worth what it can be sold at.

The fact that Third Avenue felt unable to do this is the most worrying aspect of its fund closure. There are persistent reports that liquidity in junk bonds is so poor that a request to market makers for a quote on a portfolio can be left unanswered. Bonds go “no-bid”, in other words. As a former market maker in emerging market debt, I remember from the Russian crisis of 1998 that the market could simply stop and there was no prospect of selling your holdings at all.

The risk of bond illiquidity reoccurring on its scale has been masked by central banks’ zero interest rate policies. As many have argued, putting illiquid, higher-yielding assets in funds promising daily liquidity to investors has created large-scale structural risk. In simple terms, it’s been an accident waiting to happen. Following Third Avenue Funds’ decision to suspend redemptions, the managers of other funds investing in junk bonds, bank loans and emerging market debt will be looking nervously over their shoulders.

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Today the main US-listed high yield bond ETFs, BlackRock/iShares’ HYG and State Street’s JNK, are trading at levels unseen for over two years. At the time of writing, HYG is at 88.10, down nearly seven points in price from an interim peak of 95 in late October.

Junk bond indices have been hit by the sharp post-summer decline in oil prices and fears of broader deflation: according to Dave Nadig of ETF.com, 15% of the index underlying HYG is in bonds issued by energy companies; for JNK’s index it’s 17%.

Here’s a three-year chart of HYG, JNK and Invesco Powershares’ BKLN, another high yield ETF, this time investing in senior bank loans from sub-investment grade companies. The three ETFs’ prices are rebased to 100 at the end of 2011.

hyg jnk bkln

Source: Google Finance

Over recent days many analysts have been pointing out the divergence between the weakness in the junk bond market and the relative strength of US equities. In the past such divergences have hinted at equity market falls to come, since the credit market tends to act as a leading indicator.

Unlike during previous bouts of market nervousness, the price declines in the high yield market haven’t so far been met with large-scale ETF redemptions. During the first half of 2013, the last significant sell-off, HYG and JNK lost up to 20% of their net assets, a collective outflow of $5 billion. This time round things have so far been different: Nadig noted earlier this week that the two funds have pulled in almost $3 billion in new assets so far in the fourth quarter. Of the three ETFs in the chart above, only BKLN has seen net redemptions for the quarter to date.

Here are the Q4 fund flows for the three ETFs, courtesy of ETF.com.

HYG flows Q4 JNK flows Q4BKLN flows Q4

That’s what’s concerning about recent price weakness in the sector. During previous market downturns (notably in June last year) the redemption mechanism of high yield ETFs has been put under strain. Meanwhile, by many accounts, the underlying liquidity of the corporate bond markets has worsened further.

What if the sell-off in junk bonds hasn’t even really started?

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Take two exchange-traded funds (ETFs), both on sale to retail investors, both investing in dollar-denominated high yield bonds. The funds are run by the same asset management firm, both track an index from the same benchmark provider and both promise their authorised participants (APs) the ability to create and redeem fund units daily on the basis of the underlying net asset value (NAV).

APs are the entities that transact in wholesale lots with an ETF fund issuer, an interaction that dictates how the fund is priced in the secondary market, where most of us buy and sell it.

Yet in one prospectus we read that the ability of investors to exit the fund may be curtailed in a number of circumstances. The ability of APs to redeem their fund units, says the prospectus, may be suspended if any of the principal underlying markets are closed or if the fund’s directors decide it’s difficult to determine the NAV.

More broadly, redemptions can be halted if the directors decide a suspension of dealing is in the interests of the fund, its shareholders or the investment company (an “umbrella” structure under which tens of ETFs are issued).

And even if none of these things occur, the fund may limit redemptions to 10% of the fund’s assets a day, meaning that large withdrawals may be scaled down and that those heading for the exits may have to wait.

Under any of these circumstances you could expect secondary market trading in the ETF to come to an effective halt.

In the other prospectus—remember, for a fund sold by the same firm, tracking an index in exactly the same asset class—there’s no mention of a possible suspension of redemptions.

All we read is that “if particular investments are difficult to purchase or sell, this can reduce the fund’s returns because the fund may be unable to transact at advantageous times or prices” and that, if it’s difficult to obtain reliable quotations for securities held by the fund, its manager may use a so-called “fair value” approximation of the securities’ worth in order to calculate the NAV.

Why the difference in language? The first fund operates in Europe and in compliance with the region’s UCITS rules. The second is a US ETF, operating according to the 1940 Investment Company Act, the governing regulation for US mutual funds.

A central principle of the 1940 Act is that investors should be able to redeem their fund units on demand. Unlike in Europe, where local regulators accept the possibility that redemptions may be suspended or “gated”, the US mutual fund rules dictate that fund inflows and outflows should continue even when the liquidity of underlying markets is compromised. There are very narrow exceptions to this principle, mainly relating to the closure of local (US) equity markets.

Does this difference in regional approaches matter?

In its March 2013 principles for the management of liquidity risk in collective investment schemes, IOSCO, the international coordinating body for securities regulators, accepted that liquidity crises in funds are less likely to cause systemic confidence problems than when the same occurs in the banking sector. Investors know they can lose money when buying a fund, or they should do.

But IOSCO’s principles are very high-level and non-prescriptive, no doubt as a result of the transatlantic differences in fund frameworks. In 2012 the regulatory body skirted around the fundamental gap in mutual fund rules by saying that the suspension of redemptions by a mutual fund may be justified only if permitted by (local) law.

IOSCO—whose principles are non-binding—has advised fund managers that they should not promise more frequent liquidity to investors than is appropriate for the underlying asset class and that liquidity risk and a fund’s liquidity risk management process should be effectively disclosed to prospective investors.

Again, this is subject to very wide interpretation in practice. Mutual funds promising daily redemptions (and, in the case of ETFs, instantaneous dealing), now invest on a large scale in a variety of asset classes that have been prone to liquidity crises in the past, from high yield bonds, to emerging markets equity and debt and even senior bank loans.

BlackRock, the asset manager responsible for the two ETFs I mentioned earlier (Europe-listed SHYU and US-listed HYG), has recently called for globally consistent best practices for fund structures, liquidity risk management and investor disclosure.

This is a hot topic, with those charged with ensuring the stability of the financial system now taking a much closer look at whether mutual fund run risk could cause wider contagion. IOSCO and the G-20 Financial Stability Board are due to issue a new consultation on systemically important non-bank financial institutions by the end of the month.

If a fund issuer gates redemptions in one jurisdiction, could there be a run from its funds elsewhere? I don’t know. But while local rules continue to differ so markedly, it’s hard to see how US investors are getting the same message on fund liquidity risk as those in Europe.

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US fund manager PIMCO is apparently being investigated by the US regulator for valuing bonds in its Total Return ETF differently to the prices at which it bought them, providing a temporary boost to fund returns as a result.

“The inquiry comes amid escalating scrutiny by the SEC of whether investment funds are valuing assets accurately and fairly,” reports the Wall Street Journal.

In one sense this is hardly a story at all. In another it’s a very big issue. Why?

The reasons why PIMCO’s reported behaviour may not have breached standard market practice are the following.

First, unlike in the equity market, the liquidity of the bond you’re trading depends greatly on the size of the deal.

“On a typical [corporate] bond issue, the bid-offer spread on a US$1 million transaction might be 1 percent  of par value, but for a smaller order the spread might be 3 percent  or more,” a bond trader told me a couple of years ago.

Press reports suggest that PIMCO may have been buying odd lots of bonds (with wide bid-offer spreads) for its ETF and valuing them assuming more standard deal sizes, generating an apparent (though temporary) performance boost to the ETF. This assumes that the fund manager was able to buy its bonds on the “wrong” side of the spread: at or close to the bid price. Unusual, but possible, given PIMCO’s clout.

Second, mutual fund managers’ practices in valuing bonds vary widely and typically allow the managers a great deal of discretion. Yes, managers use external pricing services, but they often retain significant control over pricing policies.

PIMCO’s Total Return ETF prospectus tells us that “portfolio securities…are valued at market value. Market value is generally determined on the basis of last reported sales prices, or if no sales are reported, based on quotes obtained from a quotation reporting system, established market makers, or pricing services,” and that “securities…for which market quotes are not readily available are valued at fair value as determined in good faith by the Board of Trustees. The Board of Trustees has adopted methods for valuing securities and other assets in circumstances where market quotes are not readily available, and has delegated to PIMCO the responsibility for applying the valuation methods.”

So if your bond is relatively illiquid and has a 3% spread between bid and offer prices you have pretty free rein to value it anywhere within that spread, as long as your approach is consistent. This practice may strike outside observers as lax, but it’s how the mutual fund business has long worked.

In 2007, academics from the Mason School of Business published a prize-winning paper showing how the same corporate bonds are priced differently by different mutual fund groups. Some fund firms priced a bond based on secondary market bid prices, others based on the mid-point between bid and offer prices. Around a third of the firms (like PIMCO) refused to tie their pricing policies explicitly to bid or mid prices and instead referred to pricing on the basis of “fair value”, a concept affording substantial discretion to the fund managers.

The academics also produced evidence of return “smoothing”: those funds that had outperformed had a tendency to mark bonds at higher prices, while those that had underperformed tended to do the reverse.

Such smoothing basically cheats one or more of three constituent groups: existing, new, or redeeming fund investors, since someone is dealing at too favourable or too unfavourable a price. But according to the plentiful evidence supplied in the paper, this practice has been going on for years, and it’s not against the rules.

Unless the SEC’s enforcement policies have changed markedly (and I can’t find any evidence for this), I can’t see how it can nab PIMCO for its valuation practices, however loose the “fair value” pricing policy might sound, that have been industry practice for years, as long as the firm was acting consistently and in accordance with the prospectus language.

Cases where the regulator has brought enforcement action against a fund group have tended to involve much more dramatic overstatements of funds’ NAV than those reportedly involved in the PIMCO case.

On a deeper level, this story is of course quite alarming. It reminds us of how deeply illiquid large segments of the bond market really are, even with the recent near-zero levels of interest rates, and how we disguise that illiquidity by putting bonds into daily dealing mutual funds and ETFs and marketing them as more liquid than their constituents. This comment isn’t aimed at PIMCO, by the way.

There’s an irony here, as well. The SEC that’s reportedly investigating PIMCO for overoptimistic valuation policies in a bond fund was long set against reforms forcing money market funds–another type of mutual structure–to value their holdings at market prices, rather than at a notional (and often fictitious) $1 a share. But that’s another story.

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Could the post-LIBOR regulatory crackdown on banks exacerbate price movements when indices are rebalanced?

Late afternoon on Friday shares in Dutch bank ING jumped nearly 5% in heavy trading on the Euronext Amsterdam exchange.

ING Price Spike


Source: Yahoo Finance

The price spike has now been fully reversed. A 5.75% increase in ING’s share price on Friday has been followed by a 4.69% decline yesterday and a further 1.23% fall so far on Tuesday morning.

ING’s late-Friday price move seems related to the reconstitution of equity indices. Friday’s market close set the price at which ING’s shares entered two indices from STOXX—the Euro STOXX banks index and the STOXX Europe 600 Banks. The latter index is a popular one: it underlies several European equity sector ETFs and is reportedly used in many bilateral swap agreements.

Both STOXX and ING declined to comment on Friday’s share price movements.

Price movements in shares entering and exiting benchmarks are a well-known phenomenon, and an unsurprising one. Index changes mean unavoidable cash flows in a whole range of tracker products, including futures, swaps, ETFs and index funds, which other market traders can try to exploit.

STOXX announced the September constituent changes for its indices on August 26 and between August 25 and September 18 ING shares had already risen 8.43%, a not-uncommon price rise between the announcement date for an index addition and the date on which the addition becomes effective.

So why the unusual late-Friday action?

According to one trader I’ve spoken to, post-LIBOR restrictions by banks’ compliance departments on their traders’ index-related deals may be having the effect of forcing market participants into the end-of-day auctions on stock exchanges, which are used to set closing prices.

Previously, said the trader, bank dealers could pre-position their trading books for index changes. Now, he argued, after the LIBOR revelations banks are scared of being seen to exploit benchmark-related trading flows. Instead, he told me, they are now taking the most conservative option: trading at the actual price point at which the index change occurs, even if this leads to a less efficient execution.

Managers of index-tracking funds and financial products face a similar dilemma: place a trade in the closing auction and risk losing money (as anyone buying ING at Friday’s close would have done by Monday morning) or attempt to trade either pre- or post-close. Shunning the closing exchange auction may mean you avoid involvement in a crowded trade, but fund managers will incur tracking error if the fund’s execution price is significantly different from the price used by the benchmark calculator.

Rebalancing-related share price movements may be exacerbated by another factor, the trader told me: the widespread use of volume-weighted average price (VWAP) algorithms. VWAP algos automatically seek to trade when volumes are highest.

“The more volume in the closing auction, the more the VWAP will seek to execute there, leading to more volume in the auction, more VWAP execution….in other words, a feedback loop,” the trader told me.

Not everyone I’ve spoken to agrees with this explanation. The ING price spike could have been caused by someone realising late in the day that they were incorrectly positioned for the index change, or even by a mistake, other traders suggested.

As the volumes of money in tracker products increase, there’s more at stake when indices rebalance. It’s clear that these events involve a trade-off between transparency and making it difficult for those seeking to game index changes. But it would be ironic if, by making trades more crowded, measures taken to clean up the benchmark business had a detrimental effect on the efficiency of indices.

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On the face of it, mutual funds are a huge global success story.

Assets in collective investment schemes have grown seven-fold in two decades and now top $30 trillion.

Growth in global mutual fund assets

mutual fund assets

Source: Investment Company Institute

Yet the mutual fund structure contains weaknesses.

First, funds need to apportion correctly the costs associated with investors entering and departing the fund, a tricky job. So-called dilution levies (also called entry fees or front-end loads) and exit fees are there to make sure that the costs of any purchases (or sales) of securities incurred on behalf of an entering (exiting) investor are borne by that investor, rather than by the rest of the fund holders.

Unfortunately, many fund managers have historically set entry/exit fees too high and used them as a disguised source of revenue.

A more important drawback of funds is that they may carry liquidity risk.

If a fund invests in less liquid assets but promises immediate liquidity to its investors, the fund manager may cope with a sudden withdrawal of investors’ funds by selling the most liquid of the underlying assets. This would disadvantage those remaining in the fund by leaving them with a rump of less liquid securities. As a result, investors are incentivised to “run” from a fund in stressed market conditions.

Given the increasingly large size of many mutual funds (including ETFs) and the potential liquidity problems in certain asset classes (like corporate debt) it’s not surprising that regulators have been focusing on fund liquidity as a potential source of broader, systemic risk.

In most jurisdictions, the managers of mutual funds have the little-advertised ability to “gate” (ration) redemptions—a right that, if invoked, could contribute to a panic.

Mutual funds have historically been expensive, too. ETFs are a welcome recent exception to the trend of overcharging, but fund fees pay for hefty salaries at asset management firms, as well as for the services of a whole range of middlemen: lawyers, accountants, custodians and transfer agents.

The world’s largest investors don’t use mutual funds: they insist on their own, flexible managed accounts. What if smaller investors could follow suit?

It turns out that they now can.

Firms like US-based Motif Investing allow you to buy a diversified, thematic portfolio of stocks in one transaction. Motif charges $9.95 for a trade in up to 30 stocks, much cheaper than online brokers’ rates for buying or selling 30 individual securities. You can customise your own portfolio (called a motif) or copy someone else’s.

You end up with an investment that’s very similar to an index fund, but with significant advantages: no annual fees, no administrative overheads, no worries about how costs are mutualised and no concerns over gating. Unlike some funds, a stock basket doesn’t lend shares, use derivatives or incur collateral risks.

Under this model you own the stocks in your motif, with full entitlement to dividends. You retain voting rights, rather than delegating them to an anonymous fund manager, who may not even use them (except, potentially, if the small size of your basket means you own fractional, rather than whole units of shares).

Mutual funds first came into being as a way of spreading risk. Reducing company-specific exposure via a shared portfolio seemed an attractive prospect for European investors recently scarred by Tulipmania and the South Sea Bubble.

But that technological advance came nearly three centuries ago. Now we can see the prospects for another significant shift in the savings market. The emergence of cheap, tradeable thematic baskets of stocks threatens to render funds obsolete.

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Active fund managers may offer poor value for money. But some index fund costs are hidden too.

Professor David Blake of Cass Business School has just released a paper in which he argues for better disclosure of the costs of active management.

Between 50-85% of the costs of active management fall outside the headline “ongoing charges” figure that every European retail fund has to display, estimates Blake.

Commissions and taxes paid on securities trades undertaken by the fund manager are excluded from ongoing charges, for a start.

Other, harder-to-measure “invisible” costs, as Blake calls them, include the bid-offer spreads payable on trades in securities, transaction costs in any underlying funds, hidden revenue earned by the fund manager from stock lending or interest, market impact costs and market timing costs.

The high undisclosed costs of active fund management are often used by advocates of passive funds as an extra justification for indexing.

Unfortunately, some of the arguments being made in favour of indexing are fallacious.

In another study published this month, Blake and co-authors Tristan Caulfield, Christos Ioannidis and Ian Tonk argue that active management is not worth paying for.

Having measured the performance of 561 domestic UK equity funds against the FTSE All-Share index over 10 years, Blake, Caulfield, Ioannidis and Tonk conclude that “the average mutual fund manager cannot ‘beat the market’ (i.e., cannot beat a buy-and-hold strategy invested in the market index), once all costs and fees have been taken into account.”

There’s a major problem with this argument. Tracker funds don’t match the market index, as Blake appears to assume as a matter of fact: they underperform as well.

Clearly, you should expect any index-tracking fund or ETF to lag its index by the annual ongoing charges, which are admittedly smaller on average than those of active funds.

But in harder-to-track equity markets the underperformance of the average index fund/ETF may be greater than the headline fee would imply. This occurs as the result of extra, frictional costs that closely resemble the hidden charges Blake talks about in the context of active management.

For an example of this effect, note that most trackers of the MSCI Emerging Markets index underperform it by more than their ongoing charges (see this recent Lyxor publication for evidence).

This additional performance lag occurs as a result of access costs: you pay more in the form of bid-offer spreads, taxes and commissions when buying stocks in smaller and less developed equity markets. Index funds have lower turnover, on average, than active funds, but they do trade.

[Disclosure—I’ve recently done writing work for Lyxor]

Index fund managers can, however, mask their funds’ underperformance in ways that are even less transparent than some of the below-the-surface active fund costs described by Blake.

One way to do this is to include extra costs in the index (whether as an index fee or, more cleverly, by depressing the assumed post-tax dividend rate in a total return index to make the fund’s performance look better).

If the index fund manager also gets to produce the index, a practice that the US regulator now appears to be condoning, then there’s even more scope and incentive to embed additional costs, to the investor’s detriment.

Another way of hiding index fund costs is to include collateral in a derivatives-based fund that is of lower quality (from the perspective of the repo market) than the quality of the securities basket represented by the index. This generates extra income for the counterparties to the repo trade, who can pocket the revenue with the average investor none the wiser that he’s losing out at all.

The equivalent practice in a physically replicated tracker fund is to exchange the index securities via a securities loan for lower-quality collateral, again resulting in extra income, a large portion of which has historically been retained by the fund issuer or its affiliate.

There’s a little more transparency regarding these practices than there used to be, and more of this hidden income is now being credited to fund investors than before. But securities lending and repo market trades are also much more characteristic of index-tracking than active funds, meriting extra scrutiny when indexing is involved.

It’s worth reiterating that if you buy an index fund assuming that you’ll get the index’s return, you are making a mistake. And if you compare index funds on the basis of their headline fees only, you are ignoring potentially substantial hidden costs.

I’m a fan of ETFs and am all for criticising active fund managers if they are providing poor value for money. But we shouldn’t give indexing a free ride as a result.

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According to the Financial Times (subscription required) the US central bank is concerned about the potential for a run on retail bond funds. The Fed has discussed imposing mandatory exit fees on those holding funds as a way of managing this run risk.

The FT reminds us that US retail investors have pumped over $1 trillion into bond funds since early 2009. Central bankers worry about investors buying funds that promise immediate liquidity while investing in potentially illiquid underlying assets like corporate bonds.

Ironically, the increasingly desperate search for yield by income-deprived investors is squarely the result of central banks’ own zero interest rate and quantitative easing (QE) policies. In recent months there’s been a top-of-the-market feel about bond ETF inflows, for example, with buyers focusing on the highest-yielding (and junkiest) part of the market, like leveraged loan funds.

I wrote in 2012 that regulators were soon likely to focus on fund liquidity risk. There’s an inherent tension between the promise of the retail fund “wrapper”—to allow investors to enter and depart at will—and the underlying assets of some funds.

In Europe, fund exit fees already exist in a rough and ready way in the form of redemption gates in fund prospectuses. If more than 10% of investors in a retail (UCITS) fund want to leave in a single day, the fund administrator can postpone redemptions until the next day.

Interestingly, some ETF issuers have told me that they’ve waived this right in the past, deciding not to halt occasional daily redemptions exceeding 10% of fund assets, presumably for fear of negative publicity.

ETFs, which are traded intraday on stock exchanges, provide a pressure valve in the sense that secondary market trading in a fund with suspended redemptions might continue—but it would be in limited volumes and presumably at a big discount to the fund’s net asset value.

We saw this happen on a small scale during a mini-panic in US-listed corporate bond ETFs last June, with one market-maker stepping away from its promise to process investors’ sell orders.

In the US mutual fund market, suspending redemptions is trickier because of the liquidity promise built into the 1940 Act structure. Fund managers must meet redemption requests within seven days and a suspension of redemptions is possible only in extreme circumstances.

At least 85% of fund assets have to be invested in “liquid securities” (I’m not sure how leveraged loan ETFs, which comply with the 1940 Act, can claim to be doing that).

You can see why the Fed is worried about run risk in junk bond mutual funds, particularly since there’s evidence that US investors are flightier than their European counterparts.

By cracking down on the banks, which can no longer hold large inventories of bonds for trading purposes, regulators have shifted risk to bond mutual funds. Now they are concerned about the consequences of their own policies.

I’ve written in the past about the potential for a crash in this sector. In particular, the shaky dealing infrastructure underlying bond funds seemed (and still seems) to me like an accident waiting to happen.

All the same, I feel uneasy about regulators’ current proposals to intervene so directly in the fund market. Investors buy funds knowing they may lose money. You can’t outlaw market bubbles and busts: they happen. If central bankers really think they can manage away all systemic risk then the next crash will be all the more violent.

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Asset managers are up in arms about regulators’ possible designation of certain firms or funds as too big to fail.

Any move to classify individual fund managers or funds as systemically important would be likely to impose onerous new capital or liquidity constraints on the entities concerned.

By comparison with banks, which have to hold substantial capital in the form of equity or retained earnings against their balance sheet loans, asset managers operate with a relative sliver of capital backing. This makes them highly profitable. But does it also make them risky?

Asset managers’ standard defence to regulators rests on three arguments: most of us don’t use leverage; we don’t guarantee the value of our funds; and, unlike banks, who act as principals, we are agents who don’t put our own balance sheets at risk.

There are some exceptions to these statements. Hedge funds—who are asset managers—are leveraged. Constant NAV money market funds in the US have long operated with something akin to a promoter guarantee of stable value. And asset managers’ expanding activity in the secured finance (repo and securities lending) markets may incur balance sheet risks for the firms involved.

As banks’ operations are crimped by new regulation, asset managers are reportedly taking up the slack in other, riskier areas of the financial markets too, like prime brokerage, trading and leveraged lending.

But for all their current lobbying dollars, asset managers may be misunderstanding regulators’ main concern—excessive scale.

The 2008/09 crisis exposed great vulnerabilities in the structure of the financial system. Its near-failure ended up costing hundreds of billions of taxpayer dollars.

From the perspective of network theory, the single riskiest type of actor in a network is one that operates at scale and with multiple links to other players.

The failure of such a “high-degree node”—one with many links—can easily bring down the whole system.

In the financial system, regulators can take action to reduce the risk of a key player failing by forcing bigger firms to hold more capital, downsize or even break up.

By comparison with banks, asset managers’ overall significance in the financial network is open to debate.

But you can see that regulators may be concerned about the huge scale of some asset management firms, and that of some of the funds they run.  Many large mutual funds promise instant liquidity while investing in less-than-liquid assets.

The investors in those funds should be well aware that the value of their holdings may fluctuate. But are they prepared for a logjam at the exit door if everyone tries to get out at once?

Add to that asset managers’ growing involvement in traditional investment banking activities and regulators are likely to err on the side of caution in classifying them. If an asset manager were at the root of the next crisis and regulators hadn’t acted, imagine the furore. Remember AIG, an insurance company, which blindsided them last time?

For this reason the largest asset managers, and the biggest funds they run, may well face new regulatory constraints.

And for BlackRock, Vanguard, Pimco, Fidelity and State Street, the largest asset managers, restructuring and reducing scale, perhaps by the demerger of different business activities, may be the way to avoid painful new capital and liquidity requirements.

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