Mutual Funds and ETFs are the “shadow banking system”
Mutual funds and ETFs can be problematic as they only provide an illusion of market liquidity, and this is a serious dilemma. To help overcome this issue, a number of money managers started to use derivatives.
They have begun to build cash buffers to help guard against potential outflows and to make the underlying markets more illiquid.
No regulations in place
One of the most frightening prospects is that this type of system has no regulations in place when it comes to maintaining reserves.
They do not even have guidelines for emergency levels of cash, which is the opposite of the FED, which is a regulated banking system. Therefore,mutual funds and ETFs could cause problems for investors.
Bill Gross, the portfolio manager for Janus Capital, said, “For now, regulators and thus large institutional asset managers are at least contemplating an inability to respond to potential outflows.Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash. Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.“
Goldman Sachs’ Gary Cohn worried about all markets liquidity, “Small buying and selling in any market today has a dramatic impact on price.” Scant liquidity might cause a “black swan” scenario similar to 1987 when stock markets declined 25% in one day as the vaunted portfolio insurance scheme met its maker due to sellers all rushing to the exit at the same time.
“Aside from the obvious drop in trading volumes, the obvious risk – perhaps better labeled the ‘liquidity illusion’ – is that all investors cannot fit through a narrow exit at the same time. But shadow banking structures – unlike cash securities – require counterparty relationships that need more and more margin if prices should decline.
That is why PIMCO’s safe haven claim of their use of derivatives is so counter-intuitive. While private equity and hedge funds have built-in ‘gates’ to prevent an overnight exit, mutual funds, and ETFs do not.
ETFs can satisfy redemption with underlying bonds or stocksonly raising the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances.
But even in milder ‘left tail scenarios’ it is the price that makes the difference to mutual funds and ETFs holders alike, and when liquidity is scarce, prices usually go down not up.
Mutual Funds and ETFs Could Be Trouble on the Horizon
Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down, and policymakers’ hands are tied to perform their historical function of the buyer of last resort. It’s then that liquidity will be tested.
“Should that moment occur, a cold rather than a hot shower is an investor’s reward, and the view will be something less than ‘gorgeous,’” said Bill Gross.
So what to do?
Hold an appropriate amount of cash so that panic of ‘selling’ is off the table for you.