Are fund management groups systemically important? There are several arguments as to why they are. However, the challenge is not so much in suggesting whether this is the case or not, but in deciding how to respond to the fact.
The reasons for attributing the systemically important label to fund groups include their potential impact on investor confidence in the event of adverse market performance, their dominant role or otherwise in key market segments, their move into the shadow banking sector, their material contribution to overall market liquidity and their vulnerability to reputational risks.
Investment funds can impact investor and thence consumer confidence in two ways. The absolute performance of the fund affects sentiment. Just as house prices are a key driver in respect of consumer confidence, so is, especially among the affluent, the performance of their investments. And funds have a critical role, and one which, with the growing importance of retirement planning as a result of the demise of many, if not most, final salary plans, is growing in significance. But, it is not only the absolute performance of funds that counts. The alternative sector has rules preventing withdrawal of money from funds as a standard. That is logical given the average size of a holding and the lack of liquidity in some underlying investments or the difficulty in unwinding some investment strategies and structures. As the alternative and traditional philosophies converge, and with the potential for small investors to act in tandem, redemption risk in retail funds is now growing.
Funds also dominate certain market segments. They have always influenced market trends in absolute terms, being the most active of the institutional segments of the market. But, with the global reduction in the private investor stake in markets, their influence is compounded. And they influence, by their order flow, the activity of other market participants with, as an example, the high-frequency trading community anticipating their actions and seeking to position themselves ahead of their decisions. Thus outflow from funds leads to sales in markets, compounded by perhaps parasitic trading activity. Such flows can become dangerous in markets where funds dominate, potentially in small to mid-cap stocks with low daily turnover but also in some of the more specialized derivative instruments that have migrated from OTC to traded markets. The hedge fund sector already dominates trading in some of these sectors, and, although it has never created solvency risk within the funds’ community, the price volatility resulting from its activities must contribute to the resultant price disruption experienced.
Funds are also a key part of the shadow banking sector. Money market funds, especially, have concerned regulators. Given the nature of the yield curve, the temptation is always to go longer rather than shorter. Given the yield differential by credit quality, the temptation is always to lend to higher than lower risk borrowers. Obviously, such a philosophy is not adopted by all funds, but, to a greater or lesser extent, it prevails. And, even where credit default swaps, where there are anomalies, are used to protect against default, they do not protect against illiquidity, nor do they eliminate all risks. The trouble with money market funds is perhaps as much in their scale as their structures. They have reached the level at which they are market critical and where their biggest challenge is avoiding the problems of banks—a structural mismatch of funds and a credit covenant challenge. And they have to do this without the benefit of retail current account flows and the better diversity of banking funding sources.
The funds also face huge contagion risk. The poor performance or problems with a single fund in a group could impact their whole portfolio of funds. Just as word of mouth rather than absolute fact starved many active traders in the past of liquidity, the same could happen for funds. But the major challenge they have is the retention of the confidence of their investor base. This is loyal to a point, but the panic withdrawals by retail investors from financial institutions during the last crisis provide a salutary example of the vulnerability of trusted names to adverse publicity.
But how does one respond to this environment? At one level action has already been taken with the moves to ensure that asset protection rules are strengthened, at least within the EU, as a result of the requirements of AIFMD and its attribution of added liability for depositories.
Another challenge has to be whether we need rules to eliminate, or at least mitigate, redemption risk in funds. Is it possible that funds could get facilities from banks to bridge a gap and ensure they are either able to wait for cash style deposit maturities or have time for orderly disposals? Over and above the likely prohibitive cost to the funds of such facilities and their strain on bank balance sheets, banks are hardly likely to rush to provide funding of an essentially illiquid position. In reality, such risks should be investor risks and met either by higher liquidity pools being retained in the different funds or the introduction of standard lock up or lock down periods for redemption funding.
Reputational risk appears to be well managed through the tighter rules being adopted in many jurisdictions for fund companies. But there remains a risk, especially from some of the tax havens where lighter regulation prevails. Fund of funds investing in vehicles in these countries could suffer by association in the event of any adverse event. And that guilt by association factor need not depend on a relationship with a delinquent fund. Just as bankers have been tarred by the activities of a minority, funds would not be protected from the court of public opinion and the illogicality of its judgements.
The debate needs to continue and there are pockets of higher risk, especially with money funds involved in shadow banking activities. But there are other challenges, especially for exotic funds in illiquid markets, for they need to ensure that redemption rules are compatible with their investment strategies. It is important, though, that size alone does not dictate risk for regulators. In reality investment strategies and fund structures are the key drivers.