Simple investment funds must be monitored for financial stability risk, says IMF

While risks from some areas of the investment industry are recognised, changes to investment products such as simple mutual funds and exchange-traded funds mean that the risk from these may be growing, the IMF said in its latest Global Financial Stability Report.

The IMF's concern has been spurred by the growth of the industry, by a larger focus on less-liquid bonds, and by concerns that in some economies many funds have been buying similar assets, said Gaston Gelos, chief of the global financial stability analysis division at the IMF.

Bond funds in particular have grown quickly, investing in less-liquid assets such as emerging market bonds and high-yield corporate bonds. This has created a mismatch between the liquidity of the fund's assets and its liabilities, because many funds let investors take their money out on a daily basis.

If a large number of people suddenly decided to redeem their investments from a fund, in reaction to an external event such as an interest rate change, that could cause a "market wide impact", the IMF said.

The IMF acknowledged that, compared to banks, investment funds offered by asset managers are less likely to default because any losses and gains are borne by the end investors.

However, several risks do exist, the IMF said in a statement about the report. It said that mutual fund investments do affect asset prices, and in periods of "market nervousness", the price of assets that are held "in a concentrated manner" by funds tends to drop more quickly.

It said that easy redemption options raise the risk of a run by investors wanting to remove their money. Some funds offer "first-mover" advantage to investors who redeem earlier, raising this risk still further. The IMF did note, however, that funds with more illiquid assets do tend to protect themselves with higher redemption fees, and these tend to be "effective in mitigating redemption pressures during stress periods".

The statement also said that asset managers increasingly engage in 'herding', or trading in the same way as their peers.

The IMF said that it is not the funds themselves that contribute to more systemic risk but the nature of those assets, and this has been changing. "The evidence calls for a better supervision of institution-level risks," it said.

Securities regulators should shift to a more hands-on supervisory approach with better data, risk indicators and analysis, including stress testing. "Establishing global standards on how to monitor and supervise the industry is essential," the IMF said.

"In particular, regulators should find ways to reduce the incentive for investors to withdraw their money when they see others exiting," said Gelos. "This could be done, for example, by well-designed redemption fees that do not hurt investors overall, for example if the revenue accrues to the fund’s net asset value. Moreover, the pricing of fund shares should be set in such a way that exiting investors do not pass on the cost of liquidity to remaining ones."