Image Credit: Christophe Vorlet
By Jason Zweig | 3:18 pm ET Oct. 2, 2015
Just about everybody but the Pope has been worrying lately about whether mutual funds and exchange-traded funds are equipped to withstand the next stock-market crash or bond collapse: activist investor Carl Icahn, the Federal Reserve, the U.S. government’s Financial Stability Oversight Council, the Bank of England, the International Monetary Fund.
Late last month, the Securities and Exchange Commission proposed a new rule that would overhaul how funds manage liquidity risk, or the potential that their investors won’t be able to cash out promptly at the prices they’ve been led to believe their fund holdings are worth.
The good news about the rule, which after some tinkering is likely go into effect next year, is that it should make funds a little safer, more transparent and more equitable.
The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are — and a rare few into bigger risk-takers than ever.
Under the proposal, mutual funds and ETFs would have to estimate the number of days needed to sell each of their holdings “at a price that does not materially affect the value of that asset immediately prior to sale.” (Good luck getting that precisely right.)
At the shortest and most liquid end — think U.S. Treasury securities or stock in Procter & Gamble Co. — would be a bucket labeled “within one business day.”
At the longest and least liquid end — perhaps some floating-rate bank loans, high-yield municipal bonds or small stocks in emerging markets — would be the “more than 30 calendar days” bucket. Assets that should take anywhere between one and 30 days to sell would go into other buckets accordingly.
All funds would have to disclose a minimum percentage of assets that they will hold in securities salable within three days at or near their current price. Those minimums would vary widely at the discretion of the fund’s managers and directors.
The rule preserves a long-standing SEC guideline that no fund should put more than 15% of its assets in securities that can’t be sold within seven calendar days at approximately the price at which they are carried on the fund’s books.
The rules seem likely to make already meek fund managers even more timid than before. The reporting requirements could prompt fund companies to say, “There’s too much risk here: Either change how you manage the portfolio or close it to new investors,” says Jeremy Smith, a partner at Ropes & Gray who represents managers and directors of mutual funds and ETFs. Knowing that, many managers will probably rein in portfolios in advance.
After all, armed with the new disclosures, fund investors will be able to compare, across otherwise similar funds, the percentage of assets that are in less-liquid holdings. They will also be able to see that one fund categorizes a particular investment as more liquid than another does.
So the more a manager deviates from holding the most frequently traded securities in a market index, the riskier the new disclosures could make his fund appear to be.
Closet indexing — in which portfolio managers pretend to think independently while, in fact, they mimic the market — will probably become even more dominant.
At the other extreme, the few managers brave enough to deviate far from market indexes may seek to make the most out of the 15% limit on illiquid securities.
If anything that takes at least seven days to sell must be characterized as illiquid, then the gutsiest managers might load up on securities that could take several weeks to unwind. That way they’d get “the biggest possible bang for their buck,” says Dave Nadig, director of exchange-traded funds at FactSet, the investment-research firm.
An old Wall Street proverb says, “Liquidity is only there when you don’t need it.” When markets come under stress, prices that looked rock-solid can vanish into thin air — a lesson many investors learned painfully in 2008 and 2009.
Until the SEC rule goes into effect, keep a few rules of your own in mind.
If a fund is sold to you as a “liquid alternative,” ponder why the marketing department insists on emphasizing that word “liquid.” Chances are, the broker or fund company is trying to make the underlying assets sound more readily marketable than they might be, especially in a crisis.
Bank loans, high-yield corporate and municipal bonds, emerging-market stocks and bonds, very small or “microcap” stocks can be slow, hard and costly to trade even in good markets. Don’t put any money into funds holding such assets if you might need to take it out in a hurry.
Finally, cash pays nothing. But if you always keep some of it around, you’ll never run completely dry.
Source: The Wall Street Journal