Wednesday, September 28, 2011

Mutual Fund Investing: Can You Be Blamed for the Global Crisis?


It is in our natures to place blame. As Doug Copland once quipped: “Blame is just a lazy person’s way of making sense of chaos.” That said, have mutual funds played a larger role in the ongoing crisis globally? And if so, why do we look to much smaller elements of the equation when the sheer size of these “investment communities” might be responsible, all be it unwittingly, for keeping the embers of (a global) recession burning?
Mutual funds as we all know are investment communities, an organized structure of similarly minded individuals (or as similarly minded as any large group can be) who seek to in many instances, lower the risk of investing by investing as one. With one theoretical manager at the helm, although we know that it can be many managers, we tend to think of them as one unit in most cases, the community gathers around their expertise and know-how in part because we believe we have limited expertise and know-how. We defer the heavy lifting and decision making to someone else. But mutual fund managers also fear us as investors. In part because we blame.
Now, this group think, achieved with only limited knowledge of what is really going on, and the fear of blame, which signals the herd that something is amiss may actually be responsible in a much greater way than previously considered, to have prolonged the fears of additional global slowing even as it should be plateauing, if not showing signs of recuperation. While the evidence to back this thinking is just emerging, the dynamics of the mutual fund do add credence to the theories being developed by Claudio RaddatzSenior Economist in the Macroeconomics and Growth Unit of the World Bank’s Development Economics Research Group and Sergio SchmuklerLead Economist at the World Bank.
First, what do we know about mutual funds and those that invest in them. Every mutual fund manager does what she/he can do to keep their finger on the pulse of those who have entrusted their money to her/his expertise. No easy task when the group is numbered among the tens of thousands. This group can find favor with the manager and inject money into the fund at such a rapid pace as to overwhelm the fund or on the flip side, pull so much of their investment out as to make the fund weaker for those who remain.
Although there has been some evidence of late that suggests that funds size has little to do with its overall returns and performance, any moves in either direction add pressure to the fund manager and their investment goals. Add to that the reasons why – disturbing financial news for instance and the pressure compounds. So we have one root cause: investors either looking to increase their exposure in one fund as they escape the other.
This creates the second reason that mutual funds play a bigger role in what the authors of a recent paper suggest: the portfolio adjustments that need to be made because of what the underlying investors are doing. Think of a bad movie, where the audience begins to head for the doors. Those remaining wonder if they should leave as well, even though many will stay for one reason or the other. In a mutual fund, the manager doesn’t necessarily bar the exits so much as adjust the portfolio in the hopes of retaining those that have remained in their seats. And we have this shift occurring to add to the problem.
The last problem is what those remaining investors say to the managers. Their input is sacrosanct and although not necessarily embraced, it is heeded. According to Radditz and Schumkler: “We find that both the underlying investors and managers of mutual funds are behind their large investment fluctuation across countries, retrenching from countries in bad times and investing more in good times.” They posit that unlike investors, the single minded type who understand that when markets sell it is because either the seller has information that no one else does or that the seller doesn’t have the information needed as simply wants out because they see danger on the horizon.
Mutual funds cannot act as agents at a equity fire-sale. They rely on the manager to do as chartered and this is often contrary to what she/he would like to do: bulk up on bargains that they know are selling at less than their true market value. They have information that you may have acquiesced by joining the fund but you simply won’t let them react. So they do what you want even if it does not seem to be in your best, long-term interest, and they sell. They sell to fund redemptions and they sell to retrench. But the key here is they sell.
While the authors of the paper point their evidence on international funds, the ripple effect is felt even in domestic, US-based funds as well that hold companies doing business on an international scale. In “normal times” the authors point out can be simply a retrenchment based on the inability of some countries to do as expected, abnormal times force a larger scale move that impacts the whole of the marketplace.
The information that investors in the these funds creates an imperative for the managers to make some sort of move to retain those investors while catering to those who have left the theater. This creates a supply-side shock to not only the fund but also to the banks of countries these funds might invest in. Call it idiosyncratic risk.
Should we blame te mutual fund? Quite possibly in part because of the mutualized investor is actually in the driver’s seat. They vote with their investable dollars and walk if there isn’t an expected return on their money. The real question lies not so much in the risk that the investors in the fund have or do not want but whether the fund is a bargain even as the risk of what it owns, increased by the departing shareholders, creates. And where does the money go? Into money market investments that benefit banks in the US while taking money from the countries who may need their borrowing/lending increased to help alleviate the crisis.

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