Image Credit: Christophe Vorlet
By Jason Zweig | 1:19 pm ET Dec. 18, 2015
On Dec. 10, Third Avenue Focused Credit Fund suspended its investors’ right to ask for their money back whenever they wish. That drastic step wasn’t unprecedented, however. It exposed a flaw that has always lurked within the heart of mutual funds — one that exchange-traded funds have largely solved.
By law, a mutual fund must allow its investors to withdraw, or redeem, their holdings at all times but “an emergency.” Thousands of funds over many decades have cashed out their investors who wished to sell, promptly and without incident.
But the risk of a “fund run” — in which investors race to pull money out while they still can — has been ever-present.
In April 1940, Securities and Exchange Commission attorney David Schenker told a Senate hearing that a run of fund redemptions — “no different from a run on a bank, Senator” — could not only depress prices for the portfolio’s holdings but would enable investors who cashed out first to get better prices than those who lingered as market prices fell.
Since investors know that, there’s always the danger that all of them will try rushing to the door first.
That concern led the SEC to permit the Reserve Fund, a money-market portfolio, to suspend redemptions in September 2008 as its holdings of Lehman Brothers debt crumpled.
And back in December 1968, the Mates Investment Fund — which had been the hottest mutual fund in the country, up 168% for the year — held 20% of its assets in illiquid shares of Omega Equities Corp., a Los Angeles conglomerate. When Omega got in trouble, Mates had to halt redemptions.
Investors had to wait seven months before they could sell — and, by then, Mates had marked its Omega holdings down to 50 cents per share from $16, a 96% loss.
Investors have forgotten such fiascos because they are so rare. On normal days, buyers come into a fund even as others are selling. The purchases generate cash that the portfolio manager can use to buy back the shares that the departing investors are redeeming.
So the fund seldom needs to dump its least-liquid holdings in order to raise enough cash to give selling investors their money back. As a result, “99% of the time, a manager can create the illusion of liquidity even in a fund that owns illiquid securities,” says Roger Edelen, a finance professor at the University of California, Davis, and a former executive at ReFlow, a firm offering cash-management services to mutual funds.
But when too many investors want to cash out at once in a panicky market, that illusion of liquidity disappears.
Fund managers may have only two choices during the kind of fire sale that Third Avenue faced.
The first, to suspend redemptions, is bad: Investors justifiably hate having their money locked up in a falling market.
But the second, to give investors their money back at will, is even worse: The more investors cash out, the more hedge funds and other predatory traders will sense blood in the water. Market prices for the fund’s holdings will sink, driving more shareholders to redeem, forcing the fund to sell even more.
Exchange-traded funds, however, don’t have to face that choice between worse and worst. An ETF investor who wants her money back doesn’t send a redemption request to the fund company. She must find a buyer in the market. In some cases, her broker sells the ETF shares to a specialized dealer called an “authorized participant,” who presents them to the fund company in exchange for an identical basket of all the fund’s underlying holdings.
For the fund manager, that’s like a swap, rather than a sale; no cash changes hands. The manager accepts the ETF shares the dealer wants to redeem; the dealer, in return, accepts an equal amount of the portfolio’s underlying securities. The ETF doesn’t have to fan the flames of a fire sale by dumping its holdings into a falling market.
To be sure, in a crash, an ETF’s price can slump below the value of its portfolio, going to a “discount” of 10% or more. “But you retain the option to trade pricing off against timing,” says Dave Nadig, director of exchange-traded funds at FactSet, an investment-research firm. If you’re afraid the price could go even lower, you are free to sell now — or you can try getting a better price later. The structure of the ETF lets you choose.
At a mutual fund that suspends redemptions, investors can only wait it out. “I think the individual investor is better off having the choice, rather than surrendering it to the portfolio manager,” says Mr. Nadig.
Mutual funds almost never halt redemptions. But with roughly $350 billion in so-called “alternative” funds whose holdings can be harder to sell, according to a recent SEC study, such halts may be more likely than in the past. If you get caught in one, you’ll wish you owned an ETF instead.
Source: The Wall Street Journal