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Structural risks in open-end mutual funds

Reaz Islam | Published: September 24, 2019 21:24:06


From my experience in trading and investing in both liquid and illiquid markets globally for over 30 years, it appears to me that Bangladesh is not yet adequately ready for open-end mutual funds due to unintended structural risks. Unless it is a money market fund that has high level of underlying liquid securities, all open-end funds should be converted to closed-end form and/or perpetual under section 20a of securities law in Bangladesh to reduce a potential of a spiralling liquidity crisis in an illiquid market.

The reality is that we cannot have a managed fund providing frequent liquidity to investors when there are no underlying securities that are liquid and easily tradable without moving the market materially. Short-term funding with long-term or illiquid instrument is a recipe for a liquidity crisis with serious consequences for any market. Open-end funds are certainly possible and also required but not in the current market scenario where limited scrips dominate and since there is no real depth of institutional investors with the exception of the Investment Corporation of Bangladesh (ICB). In order to create the right environment for open-end mutual funds, much work is required to be done by all stakeholders including the regulators. Developing a commercial paper market, tradable Treasury Bills market and other highly liquid investable assets including transferable Savings Certificates market is essential in this regard.

The daily volatility of stocks in Bangladesh is more than 1.50 per cent and therefore daily value at risk is approximately 3.0 per cent (95.0 per cent Confidence). This implies that when people buy or sell an instrument in size over two/three days the asset price can easily move 6.0 to 9.0 per cent positive (buying) or negative (selling) adversely impacting buyer or sellers. Therefore, any sizeable open-end fund seeking liquidity in the secondary market in normal cases may have serious consequences for all investors. This is clearly not the fault of open-end funds itself or the mangers but the market itself which is not prepared to absorb sizeable sale - a basic requirement for an open-end fund. 

In a down market and/or relatively illiquid market in Bangladesh when unit holders reallocate to redeem investments, the open-end fund managers are forced to sell in most cases the best quality and most liquid assets they hold. This implies that the remaining unit holders will have a much higher exposure to less liquid names, and some investors in open-end funds can be left holding the worst possible illiquid investment.  Therefore, all open-end unit holders must be fully aware of incremental risks that exist in open-end funds (relative to closed-end mutual funds) for providing liquidity. Less liquid underlying investments and potential adverse consequences triggered by other investors in the same fund who can exit under more favourable terms, especially in bear markets, may enhance the risks.

The decision of the Bangladesh Securities and Exchange Commission (BSEC) to allow to extend the tenor of CEMFs (Closed-End Mutual Funds) under Section 20a was precisely to avoid such challenges and encourage long-term investments and market stability. All participants need to realise that the price of liquidity option is not cheap in less liquid markets and can have a material adverse impact not only for open-end unit holders but also for all market participants.

 

Reaz Islam is CEO of LR Global.

reaz@lrglobalbd.com 

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