Finance, Investing

Liquidity Mismatch, the Hidden Risk of Mutual Funds and ETFs

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There is a hidden risk to investing in mutual funds and ETFs that most people aren’t aware of. It’s called “liquidity mismatch.” What is it, and how are you going to protect yourself?

 The Great Recession

The Great Recession was terrible for many hedge funds. However, it isn’t necessarily because they made bad investments. After all, a hedge fund’s job is to HEDGE its equity risk.

What many funds didn’t take into account was the absolute panic in the markets of 2008 and 2009. EVERYTHING was losing money, and hedge fund investors (individuals or pensions, endowments, and foundations, etc.) hastily yanked their money out of hedge funds. They needed the liquidity to keep on paying people’s pensions or make the payments on their yachts. The investors saw their gains wiped out and quickly got out of the market to stop the bleeding.

What was intended as a styptic instead made the wound worse. When everyone is selling, and no one is buying, the price of a security drops off a cliff. They locked in horrific losses by panicking.

Liquidity Mismatch

As hedge funds sold off assets to pay the redemption requests (sales) of their underlying investors, they quickly ran into an issue: liquidity mismatch.

The capital (liquidity) demands were higher than available liquidity. Investors wanted $100 back, but the fund only has $5 of cash on hand.

This effect is compounded by the fact that the assets that were previously at $100 only returned $70 when they sold because of the market’s sudden sell-off. Once liquidity mismatch takes hold and redemptions vastly outnumber cash and liquid assets, your money is trapped, delayed, and you receive only a fraction of the money that you asked for!

Example

Let’s say that 50% of this imaginary hedge fund’s portfolio is publicly traded stocks and bonds. Another 50% is in investments like real estate that the hedge fund is working to renovate and lease out. If the fund sells the real estate now, it has to take a substantial hit on the potential return on the investment because it’s not ready for the market yet. It has a 15% occupancy rate, and the entryway is nowhere near renovated. It’s an ugly duck. A loss is likely.

Instead of selling the real estate, which will take WEEKS at a minimum and several months and potentially years more realistically, the hedge fund sells off its stocks. Stocks are easy to sell, just click on the mouse or chunky Bloomberg terminal keyboard a few times. Click, click, done.

What happens if more than 50% of the fund’s value gets redeemed? Suddenly it’s left with no more stock to sell. This is made even worse by debt (leverage) because typically lenders call in their debt during times of distress. Lines of credit are especially vulnerable to this dynamic, as is leverage provided by institutional trading accounts.

Once a fund hits this point, it can often use something called “gating”. Gating means that they will no longer return money to investors. It can be for an indeterminate amount of time or carefully scheduled, but the point is, you’re not getting all of your money right now.

How This is Relevant to You

Unless you’re an Accredited Investor, or more likely a Qualified Purchaser, you’re probably not exposed to any hedge funds. No problem, right? Wrong.

“In December [2015], Third Avenue, the US investment house, was forced to shut its $800m high-yield bond fund after it ran out of money following redemption requests. During the summer, eight asset managers also prevented investors taking cash out of their real estate funds after they struggled to offload property fast enough to meet redemptions following the UK’s Brexit vote. The low-yield environment has caused additional liquidity problems as asset managers invest more money in riskier assets — which are harder to sell — in an attempt to generate returns.” – Financial Times, “Fitch warns fund liquidity risks are at a record high”

I was plugged into the credit community during the sharp credit correction that happened in late 2015 and early 2016. This mini-panic was enough to force a significant investment firm (Third Avenue) to shut down one of its publicly-traded funds.

The funds that faced the most issues invested in illiquid assets like real estate and high-yield debt (which becomes exceptionally illiquid during times of chaos).

Aside: Why Bond Funds Are Even Worse

Financial regulation forced banks to mostly back out of trading and making the market for bonds (holding inventory to facilitate buying and selling), so many institutional investors piled into bond ETFs to meet their liquidity needs. These bond ETFs, on the surface, offer a solution. In reality, they are bundles of dynamite with lit fuses.

Back to You

An essential tenet of the FIRE community is to invest in the stock market. S&P 500 index funds are especially popular. However, you need to understand what’s different between the pre-Great Recession times and now:

equity, etf, inflows, early retirement, personal finance, financial independence

Institutional investors have PILED IN during this bull market. ETFs were created to help you and I (retail investors) invest in the market cheaply, but they’re now held hostage by entities with billions of dollars of assets under management.

The amount of capital in equity ETFs is more than 2x what it was in 2008 peak and over 8x what it was in the depths of the Recession! All else being equal, this extra volume just exacerbates these liquidity issues.

The same chart for the high-yield corporate bond ETF market is even worse, as the low-interest rate environment has forced institutional investors to hunt for yield further out on the risk spectrum.

Mutual Funds

It’s not only ETFs that you need to think about. Mutual funds are also at risk. The golden calf of the FIRE community, Vanguard mutual funds, could even have problems (along with any other mutual fund).

Below, I’ll paraphrase some key conclusions from an academic paper (“Cash Management and Extreme Liquidity Demand of Mutual Funds”):

  • mutual funds are subject to a lot of risks because their shares are redeemable daily
  • the funds meet redemption requests by selling assets or with cash they have on hand
  • if funds hoard their cash and sell assets, collectively, they will create a fire-sale environment
  • if there are far more sellers of funds in the market than buyers, the prices of the funds will gap-down (sell-off) quickly
  • funds with low levels of cash will add significantly to liquidity issues in the market

Protect Your Asse(t)s

We all know that markets go up and down, sometimes drastically. Now that you know that mutual funds and ETFs may implode temporarily during the next market shock, what can you do to protect yourself?

  1. Increase your emergency fund – if you have a six-month emergency fund, consider increasing it to at least a year. This is especially true once you’ve reached FIRE. Augment your emergency fund so you can keep from selling any shares for at least year. I say “at least” because what if another emergency happens during this period? Riding out a year of market insanity without selling anything will probably put you way ahead of other people who panic-sell.
  2. Shift some money to “real assets” – real estate rental properties, timberland, farmland, music royalties, a coin-op laundry or snack machine business, anything that produces a cash yield and is likely to continue doing so during a recession. If you can cover your necessary living expenses without ever touching shares or dividends, even better.
  3. Sit tight – when you see the talking heads on CNBC and Bloomberg losing their minds and your friends and neighbors fretting, ignore the noise and take comfort that the previous two strategies have got your back. If you’re prone to make an emotional selling decision, or you’ve never held stocks through a mass sell-off, consider looking at your portfolio less frequently. By sitting tight, you help alleviate the feedback-loop as the ETFs/mutual funds sell-off. We’ve never had this situation happen in scale before, so it’s all unknown, but losing your sh*t never helps any situation.

Conclusion

I’m by no means trying to persuade you to delay your early retirement, that’s not the point here. If you’re running for the exit, I’m not stepping in your way!

Just consider bolstering your wealth further once you’ve hit FIRE. If you look around, you’ll see that many people in the FIRE community continue to make more money than they spend, even in retirement.

Further Reading:

Could bond funds break the market?

Fitch warns fund liquidity risks are at record high

Liquidity Trap?

Time Horizons, Liquidity Mismatches And Investor Expectations

ETF Liquidity Trap Will Get You

Did you know about liquidity mismatch? Are you going to do anything about it? What are some of your ideas?

 

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