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Is Your Mutual Fund Safe?

March 23, 2001

Tags Financial MarketsU.S. Economy

Mutual funds are open-end investment companies that offer their shares to the public and redeem them on demand. They pool the savings of their shareholders and invest them in stocks, bonds, government securities, and short-term money-market instruments. During the last ten years, they have attracted nearly one-half of the net growth of household savings. While small-time deposits in banks have declined significantly as a percentage of total savings, mutual fund holdings have risen spectacularly.

Most mutual funds pay higher returns than competing banks and offer check-writing services that have grown to compete in quality and quantity with those provided by banks and thrifts. Despite the absence of government-backed deposit insurance, mutual funds have succeeded in becoming fierce competitors to the traditional banking institutions by offering an opportunity to participate directly in the fortunes of the stock and bond markets. The value of their shares depends on current market value of the portfolio; shares are redeemed at this value. As the stock market has risen phenomenally in recent years, from a 3,000 Dow Industrial Average in April 1991 to some 11,000 in January 2000, the net asset value of many mutual shares has soared to astonishing levels. 

The recent decline in stock prices raises a concern about the fragility of the new financial order. How safe are the mutuals, and how safe are the funds invested in the mutuals? How vulnerable are they to the financial crises and panics that are the inevitable concomitants of boom-and-bust conditions? During the mid-'90s, more than a dozen mutuals suffered substantial losses amounting to hundreds of millions of dollars. They experienced portfolio losses primarily as a result of their inept use of highly leveraged derivatives such as futures and options contracts. But in most cases, the fund managers made up the losses and protected investors from meeting with a loss. The Paine Webber Group, Bank America, and Barnett Bank, for instance, provided the cash infusions needed to cover the losses.

The greatest concern about the safety of the financial structure, however, is not the poor handling of dangerous derivatives by incompetent management; the greatest concern is a sudden sharp decline in stock and bond markets that may spook fund investors. Panicky investors may force fund managers to liquidate their portfolios, causing stock prices to plummet. If millions of mutual investors should stampede out of their holdings, would they not cause a "mutual fund death spiral"? Would shareholder-runs on mutual funds not destabilize all financial markets?

This "death-spiral" notion rests on the assumption that mutual investors are rather unsophisticated and are subject to a "mob psychology." They presumably buy in up-markets, sell in down-markets, and stampede for the exits when prices tumble. Obviously, such a summary description of all mutual investors is obviously shallow and prejudiced. As in all other fields of economic activity, mutual investors represent the whole range of human ability, from the shrewdest and most sagacious speculator to the most inexperienced. Essentially, they do not differ from all other investors.

Individual differences in ability, perception, and preference are visible in the great variety of mutuals with different objectives and degrees of risk. Investors enjoy a large selection of funds, from the most conservative money-market funds and relatively conservative growth and income funds to speculative aggressive-growth funds, international funds, and index funds. Investors may choose to move from one level of risk to another. 

In 1997, for instance, when interest rates rose and market volatility increased significantly, investors slowed their purchases of equity funds and even pulled money out of aggressive-growth stock funds. Some mutual funds that specialize in stocks of small, fast-growing companies faced sizable redemptions. Investors' ardor for index funds, which invest in companies whose stock is used to calculate the indices, cooled considerably. Money flowed into money-market mutual funds (MMMs), which serve as parking places when investors are nervous about the stock market.

The safety of any mutual fund obviously depends on its asset composition. MMMs are believed to be safe and secure. Their primary investment usually consists of commercial paper. Other holdings include U.S. Treasury bills, repurchase agreements, certificates of deposit, Eurodollar CDs, bankers' acceptances, and cash reserves. The commercial paper component—which consists of unsecured money-market obligations issued by prime-rated commercial firms and financial companies, with maturities of mostly under thirty days—entails some risk flowing from the vulnerability of the issuers. 

MMMs labor under numerous Securities and Exchange Commission restrictions that limit their holdings of commercial paper of any single company to 5 percent of total fund assets and limit total holdings of securities with less-than-highest credit rating to 5 percent of fund assets. Although a few companies defaulted in recent years, the money market mutuals continued to redeem their shares in full. The funds' advisors injected sufficient funds by purchasing the defaulted paper at par value, which protected shareholders from bearing the losses. 

Short of radical governmental intervention, it is unlikely that many prime-rated companies should ever falter simultaneously and thus seriously test the solvency of money-market mutuals. And it is improbable that defaults by commercial paper issuers would trigger a shareholder run on MMMs. After all, there is little danger of bankruptcy, because mutual funds, including MMMs, have no legal obligation to redeem their shares at any value but market. 

Every mutual can meet its redemption request at all times and in all situations. If it experiences losses, it may pass them through to shareholders through reduction in the value of its shares. In this respect, it does not differ from a corporation whose stock is traded publicly; if the value of that corporation's stock declines, the owner suffers the loss while the corporation remains unaffected directly. The same is true for mutual funds, including MMMs.

Stockholders always have a powerful incentive to rush to the exits when prices plummet and losses mount. After many weeks of distressing declines, the panicky behavior of multitudes of investors effects the crash. It is a common phenomenon of the business cycle, the consequence of mass consternation and abject fear of a readjustment. At first, only a few astute investors observe the end of the boom and, in an orderly fashion, begin to liquidate their bullish holdings. Gradually, other investors perceive the change and follow the new trend. As more and more trend-watchers join in, the decline turns into a run and, finally, a "crash," as millions of latecomers rush to the exits.

As distinct symptoms of the business cycle, stock market crashes are unavoidable once the boom has started and a financial bubble has formed. The 1991-2000 bull market, which saw stock prices soar to unprecedented levels, was a fertile breeding ground for violent crashes. The readjustment has begun slowly, but it may accelerate until panic fear seizes the multitudes of trend-followers. 

On such a day, several billion shares may change hands on the New York Stock Exchange; stock prices may plummet at least 10 percent; and a trillion dollars of stockholder wealth will evaporate in a few hours. The day will go into financial history as another black day of inexplicable desperation, which legislators and central bankers who created the bubble undoubtedly will lay on the doorsteps of bankers, speculators, and foreigners.

Mutual fund managers must brace themselves for a wave of fund redemptions—just as brokers and market makers must prepare for a flood of sell orders. But will mutual shareholders make matters worse by causing a cascading sell-off in the stock and bond markets? Will mutual fund redemptions calm the waters, or will they aggravate the panic? 

The coming crash probably will be of major magnitude because, in recent years, investment companies managed to attract multitudes of investors who had never before invested in corporate stock. Since 80 million to 90 million Americans are believed to be mutual fund shareholders, it is unlikely that the vast majority of these investors are prepared to analyze the income statements and balance sheets of the corporations whose stock is held by their mutuals, or that they can examine the great variety of forces that move the markets. They are trend-watchers and trend-followers, always ready to follow the leader. When stock prices fall, they are likely to sell. When stock prices plummet, they will rush to liquidate. They are the power-pack of the crash.

The financial conduits of these shareholders, the mutuals, will be in the center of the crash. While millions may react to retrieve their savings, forcing the mutuals to liquidate their holdings as fast as the demands for redemption come in, many may merely want to shift their investments from speculative equity funds—in particular, the index funds—to the money-market and hedge funds that seek to offset the risk of loss with a variety of techniques, including futures contracts and options on futures. 

In order to allay the fears of their panicky stockholders, the mutuals may offer twenty-four-hour telephone service to receive switch and liquidation orders. While the shareholders may suffer serious losses in a crash, the solvency of the mutuals can rarely be in doubt—unless the flood of redemptions reduces the size of the mutual to puny levels that no longer support the managers. A fund must have at least $50 million in assets and the prospects for growing to $100 million in order to cover its costs and pay its management.

In a crash, some funds are likely to grow in size and prestige. The hedge funds, money-market funds, and bear funds may prosper as others visibly shrink in size and struggle for survival. The precious metal funds, in particular the gold funds, would enjoy a new luster if and when the U.S. dollar should crash in world money markets. 

Throughout the ages, people have sought refuge from natural and man-made calamities in the possession of natural money, gold, and silver. They are likely to remember gold and silver when their dollar savings suddenly shrink in the maelstrom of a crash and recession. It is unlikely that massive fund redemptions would destabilize an unhampered market. However, several Security and Exchange Commission regulations designed to stabilize the situation may actually aggravate it and cause some mutuals to default.

Although mutuals are contractually bound to honor redemption requests at closing prices on the business days on which such requests are made, regulators give them seven days to liquidate assets and make payment.

This provision alone should make for numerous defaults if the fund managers, in the hope that prices will recover, delay the liquidation of assets and if stock prices continue to fall. The law also permits mutuals to borrow funds instead of liquidating assets, which should bankrupt many borrowing mutuals when prices continue to decline. 

Under the Investment Company Act, the SEC is authorized to suspend the redemption obligation. In typical government "newspeak," the SEC may suspend payment in order "to protect mutual fund shareholders." It protected them by denying redemption in 1963 when President Kennedy was assassinated, in 1977 when New York City suffered a power blackout, in 1986 when the municipal market broke, in 1987 when the Hong Kong Stock Exchange closed, and in 1990 when lower Manhattan suffered a power failure. Surely there will be more suspensions.

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Hans F. Sennholz, Emeritus Professor of Economics at Grove City College, is an adjunct scholar of the Mises Institute. Send him mail and see his Mises.org Daily Articles Archiveand his Personal Website

See also Let the Recession Run Its Course by Martin MasseWhat Happened to Japan? by William Anderson,  Business Cycle Primer by Llewellyn H. Rockwell, Jr.,  Boom and Bust and Boom and Bust (Part 2)  by Gene Callahan, and, for deeper reading on the subject, the Austrian Study Guide on Business Cycles.


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