Mutual Funds|Gauging Funds' Emergency Preparedness
https://nyti.ms/1sePI0f
Gauging Funds' Emergency Preparedness
Leveraged loan funds can focus on loans that are more liquid and could be sold more easily to raise cash. Oppenheimer's Senior Floating Rate fund, for example, holds loans to big companies like Hilton, whose Millenium Hilton hotel in Manhattan is shown above.Credit...Mark Lennihan/Associated Press
By Peter Eavis
WHENEVER markets are hot, mutual fund companies tend to go far off the beaten track in their hunt for better returns.
Perhaps too far.
The ultralow interest rates of the last several years have stoked a demand for mutual funds with higher returns. Most of that mom-and-pop money has gone into mainstream mutual funds that make simple bets on the major stock and bond markets. But a large chunk of it has been plowed into funds that have taken much more adventurous approaches. Hugely popular in recent years are funds that invest in opaque debt markets or deploy hedge-fund-like strategies.
But now, regulators and even some fund company executives are asking what might happen to such funds if their shareholders want to redeem them en masse during severe market turbulence.
Many of these funds have investments that are "illiquid," the Wall Street word for assets that rarely trade or would be hard to sell quickly. In a market rout, when many shareholders are trying to get out, illiquidity of assets could become a big problem. Specifically, the funds might not be able to sell the investments fast enough to raise the cash needed to make timely payments to the departing shareholders.
"A fund that does not manage liquidity risk in its portfolio could have difficulty meeting redemptions if it came under stress," Mary Jo White, chairwoman of the Securities and Exchange Commission, said in a speech in December.
The commission has a longstanding rule that says fund investors must be able to get their money out of a mutual fund within seven days.
Mutual fund specialists who cater to retail investors have been highlighting the potential dangers of funds that have illiquid assets.
"As investors go through the process of picking mutual funds, it's something that everyone in that process needs to be thinking about," Sumit Desai, an analyst at Morningstar, said.
Ms. White said the commission was scrutinizing funds to assess several potential areas of risk. She noted that one focus was the liquidity of mutual fund holdings. The review may lead the commission to propose new rules for mutual funds, including new regulations on illiquid assets.
The commission is not setting out to shield retail investors from losses when markets fall. Instead, its aim is to make sure that mutual funds have not strayed beyond their core mission, which is to provide transparent investments that don't spring nasty surprises.
And the danger of that happening increases as fund portfolios veer from the main stock and bond markets, some asset management analysts say.
"In mature bull markets, you do see people in the mutual funds space going into illiquid assets," said Stephen Tu, an analyst at Moody's Investors Service who covers asset management companies. "Anytime the funds venture into investments that are not publicly traded, it entails new risks."
The fund companies say they have taken precautions that will ensure that the mutual funds have the cash to make payouts to shareholders — and they note that mutual funds held up well during the 2008 financial crisis.
But the growth of funds that might have illiquid assets has caught the eye of several regulatory agencies.
The S.E.C., for instance, is currently reviewing "alternative funds," which, like some hedge funds, may engage in complicated strategies that can be difficult to unwind. Ten years ago, alternative funds had $33 billion in assets under management; now they have $456 billion, according to data from Lipper. During the financial crisis, many hedge funds had to restrict withdrawals by their investors. And another severe market shock could test these alternative mutual funds, Mr. Tu said.
Some concerns right now revolve around mutual funds that invest in leveraged loans.
These are bank loans made to companies with low credit ratings. The loans are mostly illiquid and they have yields below those on junk bonds. Even so, mutual funds have found certain features of the loans attractive. The assets of the borrowing company secure the loans. And the interest rate on the loans moves higher if benchmark interest rates go up.
An archaic feature of the leveraged loan market could present particular problems for mutual funds. When funds sell stocks and most types of bonds, they can count on getting the cash from the sale in three days.
But with leveraged loans, it can often take two weeks or more, far longer than the seven days mutual funds have to make redemption payments to shareholders. So if many shareholders tried to leave a leveraged loan fund at once, the fund might struggle to raise enough cash in time.
Companies that manage leveraged loan mutual funds say they have made preparations to deal with potential illiquidity problems.
One large fund, Oppenheimer's Senior Floating Rate fund, has a $2.5 billion credit line that it could draw on if it needed cash to meet redemptions. In a recent interview, Joseph Welsh, a manager of the fund, said Wall Street banks have shown so far that they can help mutual funds quickly sell leveraged loans.
Mutual funds can also focus on loans that are more liquid and could be sold more easily to raise cash. These might include loans to large and prominent companies. Mr. Welsh's fund, for instance, holds leveraged loans made to Hilton and American Airlines. "People ought to know we're lending to some of the biggest companies in the country," he said.
The fund had $19 billion of assets under management at the end of 2013 and experienced outflows of $1.56 billion last year, according to data from Morningstar. It returned 0.55 percent in 2014, in line with the 0.58 percent average gain for bank loan mutual funds.
FUND companies say they have been able to meet redemptions during past periods of turbulence because they have taken very seriously the requirement to be able to pay out within seven days, said Robert C. Grohowski, senior counsel at the Investment Company Institute, which represents asset management firms. "That is one of the bedrock, sacrosanct legal-regulatory requirements for anyone who runs a mutual fund," he said, "That is one section that you don't play fast and loose with."
Fund managers also point out that the recent outflows from leveraged loan funds have not stopped departing shareholders from getting their cash in a timely manner.
Appetite for leveraged loans has fallen in recent months as investors have pulled money out of a range of riskier markets around the world. Mutual funds and exchange-traded funds that invest in bank loans — mostly leveraged loans — experienced $13.8 billion of outflows from the end of 2013 through November 2014, according to Morningstar. The outflow is equivalent to nearly 10 percent of the $144 billion in assets held by the loan funds at the end of 2013.