The number of people pulling their money from mutual funds and ETFs is accelerating at an alarming pace. Fund outflows are running at the highest rate in over two years.
Conventional wisdom may be pinning the blame for this rush to the exits on the sudden failure of three junk bond funds in three days, including Third Avenue’s Focused Credit fund. However, investors are bailing on funds across the spectrum — bonds, equities, commodities, all are seeing massive redemption requests
Junk Bond Contagion
The week ending December 16th saw the heaviest fund outflows since June 2013 – two and a half years. Fund tracker Thomson Reuters Lipper has chronicled the carnage. Speaking of the rate of redemptions, Tom Roseen, head of research services for Lipper, said “We saw some very large redemptions, in fact, we set some records.” Surprisingly, the $3.8 billion fleeing the high yield (aka junk bond) sector wasn’t the worst news. $5.1 billion jumped ship in investment-grade bond funds, the largest level of weekly redemptions since records began in 1992. Stock funds saw their assets under management drop by $11.1 billion for the week, and bond funds as a whole saw $12 billion head for the door. Even diversified funds, which hold both stocks and bonds, had $5.6 billion worth of shares redeemed last week. U.S. funds that invest in foreign stocks were not immune to the stampede, losing $3.6 billion in outflows.
All told, approximately $28.6 billion were withdrawn from mutual funds for the week ending December 16. About the only areas that saw inflows for the week were super-safe bonds. $647 million found a new home in municipal bond funds for the week. Treasuries funds welcomed $539 million in new investment, snapping three weeks of outflows.
What’s Going On???
While a good bit of fund outflows are people fleeing investments that they suddenly see as losers or too risky, there are a couple other contributors. One is selling losing investments for tax-loss purposes. Investors can cash out of an under-performing fund, and write the loss off against profits from other sources. Another factor is the necessity of fund managers to liquidate some holdings to pay out year-end distributions to shareholders. Since these numbers cover the week up to the FOMC interest rate decision, some of the withdrawals were likely some money moving to the sidelines to see what the immediate aftermath of the Fed policy decision would be.
Still, this doesn’t explain the net outflows from funds that have occurred every month since July. For the first six months of 2015, funds saw inflows each month. But sentiment turned around in July, about the same time headlines were reporting the flight of retail investors out of the stock market.
Junk Bond Collapse
The spectacular, unexpected collapse of Third Avenue’s Focused Credit Fund on December 10 threw the spotlight on the dangers of holding junk bonds. Two days later, Stone Lion’s oldest fund suddenly went belly-up, leaving investors in the lurch. The next morning, Lucidus Capital Partners announced a fait accompli, announcing a last payout to investors after having liquidated all assets and shut the company down without telling anyone. Shell-shocked investors panicked, sparking runs on other high yield funds that then spread to the investment grade sector.
Several factors set junk bonds up for the fall. One was the insatiable chase for yield by both hedge funds and retail investors, who forgot that you only get high yields by taking high risks. Before the world of zero interest rate policies by the world’s central banks, junk bonds were usually held by long-term by large institutional investors, who recognized the risks and knew this was a contrarian play.
Another factor was the implementation of financial regulations designed to prevent another taxpayer bailout of Wall St. banks. These banks are no longer allowed to hold large numbers of junk bonds. Previously, investment banks would take junk bonds off their clients’ hands in a downturn, and flip them for a profit when the market recovered. This has greatly affected the liquidity of the junk bond market.
No Escape From Failing Funds
Junk bond fund outflows are presenting investors with a dilemma: Do you hold on to see if the fund recovers, or do you bail? The thing is, if you wait too long, the fund could fail and only redeem a small part of your investment. Junk bonds are some of the most illiquid assets. The lower the rating, the more difficult they are to sell on short notice, or even assign a price. Some of the lowest-rated bonds may only trade a couple times a month.
When a junk bond fund is hit with a large amount of redemptions, the fund manager has to sell his most liquid (and usually most valuable) bonds to pay out to investors. As funds start failing in a domino effect, the run for the exits accelerate. Much like the “bank runs” of yesteryear, which caused otherwise viable banks to fail, the more people that demand their money from these funds, the more likely more funds will suspend redemptions, or fail outright.
Jumping First May Be The Best Strategy
This creates what is known as “first mover advantage.” The first investors to bail will get the stated value for their shares. As redemptions increase, the fund manager runs out of liquid assets, and is force to dump the lower-rated assets at fire sale prices. This makes the remaining shares in the fund worth less. People who get out of the fund later get less for their shares, because the share price of the fund is more than what the fund can sell their assets for on short notice.
It may be too late for many investors, including pension funds and “mom and pop” investors. The Wall St. Journal notes the staggering fund outflows of the ten most troubled junk bond funds:
Do You Know What’s In Your Fund?
Many investors have no idea what their fund is actually investing in. Even professionals who read a fund’s prospectus can come away confused. In a grab for yield, fund managers will quietly buy ever more risky assets. A retail investor reading a list of the fund’s holdings would likely have no clue at all how risky each asset was. For example, Third Avenue held triple the average number of the riskiest junk bonds.
It’s too early to tell how far and how long these accelerated fund outflows will continue. The fact that investment-grade bond have been hit so hard by redemptions in the last two weeks is spooking some investors. Many analysts point to the fact that a downturn in the bond market is often a leading indicator of a falling stock market. This is spreading fear contagion into the broader market. The US stock market is looking to barely break even for the year, which will be the worst performance since 2011.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.