“First-Mover Advantage” in a “Liquidity Mismatch”: How slow-poke investors in conservative-sounding mutual funds can get their faces ripped off.
When it comes to conservative-sounding open-end mutual funds, particularly those invested in bonds, loans, thinly traded stocks, real estate, and the like, “first-mover advantage” means: When there are signs of trouble, get out early. Because if you don’t, you can get your face ripped off.
“First Mover Advantage” is known, which is part of the problem.
Astute fund investors know about the first-mover advantage. So they keep an eye on the markets, and when they see stress in the asset class that the open-end mutual fund is invested in, they pay close attention. And when the first warning signs appear in the fund itself, they get out of the fund. “Open-end” mutual funds are those where investors can on a daily basis buy shares from, or sell shares to the fund sponsor to get into or out of the fund.
“The liquidity mismatch.”
But when investors sell shares back to the fund, the fund has to sell some of its assets to meet those redemptions. This is not a problem when these assets are very liquid, such as large-cap stocks. But when these assets are bonds, loans, or real estate, that cannot be easily sold within hours – it may take days or weeks for some of them – then there is a mismatch in liquidity between what the mutual fund offers to its investors (daily liquidity) and what the fund holds (largely illiquid assets that are difficult to sell quickly without a punitive discount).
This “liquidity mismatch” is also what makes banks risky, and why bank deposits are insured. But mutual funds are not insured.
“A run on the fund.”
When enough investors worry about the fund getting in trouble and are trying to use the first-mover advantage by yanking their money out before all heck breaks loose, the open-end mutual fund faces a “run on the fund” and is forced to sell large amounts of illiquid assets to meet redemptions. But the only way to sell them quickly is to sell them at ever lower prices, and the longer investors stay in the fund, the more they lose.
How this played out in reality.
Many open-end bond mutual funds collapsed and were shuttered, with slow-poke investors getting their faces ripped off. Here is a big example of just how bad this can get.
Before the Financial Crisis, Schwab marketed a family of bond mutual funds – Schwab YieldPlus Select (SWYSX) and Schwab Yield Plus (SWYPX) – as conservative alternatives to money market funds, with just a tad higher yield. In 2005, the yield was about 5.5%, when the 10-year Treasury yield was between 4% and 5%. At the time, the fund had about $14 billion in assets, which was a lot of money back then.
The top 10 holdings, which is what investors could see listed, was the usual mix of Treasury securities and investment-grade corporate bonds, and some highly rated corporate paper. Beneath the skin, 45% of the funds’ holdings were mortgage backed securities (MBS), including many backed by subprime mortgages. Most of them were highly rated as well.
But smart investors in Schwab’s conservative-sounding open-end bond mutual fund kept their eyes on the markets. And when the tide turned in the housing market, they started paying attention, and then they saw that people were defaulting on mortgages, as home prices were dropping.
This was the first warning sign. These astute investors sold their shares of the fund back to Schwab and got their money out, after having earned the juicy yields for years. They had the “first-mover advantage” because what came after them turned into a nightmare for slow-poke investors.
The fund had to sell assets to meet these redemptions. It sold its most liquid assets first because it could sell them without losing money: Treasury securities. That was the fund’s cushion, and the fund burned through it.
When the redemptions continued, assets in the fund began to drop rapidly. This was the second warning sign.
It confirmed to investors that the fund was forced to sell assets because first-mover investors were cashing out. Seeing this, more investors got nervous and yanked their money out. Now the fund had to sell less-liquid assets, such as its best corporate bonds. But under pressure to sell, Schwab’s fund and other funds in a similar position drove down the price of those bonds, and as prices dropped, the Net Asset Value (NAV) of the fund began to drop sharply.
This was the third warning sign. And more investors figured out that this fund was stressed, and that they had better get out now. They sold their shares back to Schwab, which now had to sell even less-liquid assets and there were fewer buyers for them, as the whole market was beginning to get stressed. By that time, Schwab was experiencing a full-blown “run on the fund.”
And then something weird happened: As the Treasuries and other high-quality bonds had been sold, the MBS holdings began dominating the list of the top 10 holdings.
By that time, the mortgage crisis was in the media. The fund’s NAV was dropping every day. Folks who still held shares of this fund and looked at the top 10 holdings and knew what they were looking at got scared and sold their shares back to Schwab, and Schwab was finally forced to sell these MBS when the bottom was falling out of MBS market.
As mark-to-market fails, slow-pokes eat the losses of First Movers.
Bank-issued MBS in a stressed market were difficult to price on a daily basis because for some of the issues there were no trades in days or weeks. These holdings may not have been marked to market properly – and when the fund was forced to sell them at whatever it could get for them, namely cents on the dollar after Lehman had collapsed, there was a huge plunge from book value to the sold price.
But the first movers were paid based on the possibly pristine value at which these MBS were carried on the books of the fund at the time. The slow pokes were paid on the price the fund actually received from selling them. In other words, the first movers should have taken some of the loss of those MBS, but didn’t, and what should have been their losses ended up falling on the slow-pokes.
The fund size plunges.
From its $14 billion in assets in 2005, the fund dropped to $13 billion in May 2007, to $6.5 billion in January 2008, to $2.5 billion in March 2008, to $500 million in July 2008, to about $210 million in October 2009, by which time the fund had been shuttered.
Net Asset Value plunges, and there is no recovery.
First movers got all their money out. Investors that hung in there long enough lost between 40% and 50% of their principal that they had invested in this conservative sounding bond mutual fund.
Unlike the prices of stocks or bonds that investors hold outright, bond mutual funds that experience a run cannot recover because the fund is forced to sell the assets, and they’re gone, and when prices of those assets recover, someone else owns them and takes the gain. A run on the fund is a one-way event that is permanent loss to fund holders.
Lawyers get rich.
Over the following years, lawyers got rich in the ensuing waves of litigation. Schwab ended up settling countless individual investor lawsuits and class action lawsuits mostly for cents on the dollar. Actual payouts to aggrieved investors, after the lawyers got their cut, were minuscule.
Hedge funds et al. get rich.
Hedge funds and others that bought those distressed MBS for cents on the dollar from the Schwab fund when it was forced to sell them made a killing by selling them at face value to the Fed.
Other open-end mutual funds that did not experience a run on the fund survived the period more or less intact.
The risk is never priced into open-end bond or loan mutual funds.
The risk that an open-end fund with illiquid assets can collapse when it experiences a run is never priced in. This risk is a one-way catastrophic loss. But investors are not paid for taking this risk. Most fund investors shoulder this risk, thinking it doesn’t exist.
All major central banks have been warning about the risks posed by this type of liquidity mismatch, including the Fed, due to implications for financial stability. A run on the fund — if it is a broader occurrence as it was during the Financial Crisis, where funds were forced to sell large amounts of illiquid assets — can destroy prices of those bonds and loans. This explodes yields to where companies can no longer afford to borrow and as a result will have to default on their existing loans and bonds and then cannot meet payroll…
What smart investors do.
There are reasons to own open-end bond funds or loan funds. But smart investors that hold these funds don’t relax. They know they’re not being compensated for the risk of a run on the fund. They keep an eye on the market, and when the market for the assets in the fund gets shaky, they start paying close attention to the fund, and when they see the first feeble warning signs that a run on the fund might be happening, they grab the first-mover advantage while they still can and get the hell out.
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