(Bloomberg Opinion) — “If the ETF came first, the SEC would never approve the mutual fund structure.”
I keep thinking about this quote from Matt Hougan, former chief executive officer of Inside ETFs, which I cited in a Feb. 19 column titled “Mutual Funds Are Not Long for This ETF World.” I argued that the Federal Reserve’s unprecedented intervention in the U.S. corporate bond market was a plot to rescue fixed-income mutual funds from potential disaster and that the coronavirus crisis would only hasten the rise of exchange-traded funds in their place.
Since then, two of the most influential U.S. policy makers have been candid about the fact that bond mutual funds pose a unique and serious problem during times of market stress. First was Fed Governor Lael Brainard during a March 1 speech on preliminary financial stability lessons from a year ago:
Then, during an exchange with Senator Elizabeth Warren of Massachusetts on March 24 about the Financial Stability Oversight Council, or FSOC, Treasury Secretary Janet Yellen brought up how the open-end mutual fund structure can create “fire sales”:
That discussion previewed Yellen’s first FSOC meeting last week. Bloomberg News reported that one of her priorities is evaluating vulnerabilities in “nonbank financial intermediation” and determining what changes should be made, particularly to open-end mutual funds that “offer investments with greater liquidity than their underlying assets.” Brainard, in her speech at the start of March, had one possible solution: Swing pricing.
The premise is relatively straightforward. If redemptions are so high that a mutual fund has to sell relatively illiquid securities into a declining market, that’s going to penalize those who remain invested and don’t immediately pull their cash. To offset potentially steep discounts on the assets, portfolio managers can pass the cost along to those who chose to withdraw money. Otherwise, there’s an inherent advantage to being among the first to run during moments of panic. The goal, in other words, is to incentivize investors to keep their money locked up in mutual funds rather than flee.
At first glance, it certainly seems as if this kind of regulatory shift could bolster the stability of mutual funds and prevent another near-collapse like the one in March 2020, when the Fed had to backstop the entire U.S. bond market. The question is whether such a policy is worth the risk of potentially accelerating the demise of the mutual fund industry in the process.
For one thing, open-end mutual funds already have the power to implement swing pricing after the Securities and Exchange Commission voted 2-1 in 2016 to allow them to cash out investors at less favorable pricing during market turbulence. Yet by all accounts, few managers in the U.S. actually do this. It’s possible that the current guidelines around “swing factors” and “swing thresholds” only need to be tweaked, but the complete lack of interest in this kind of buffer suggests there’s something inherently unpalatable about penalizing investor withdrawals, even if the policy is meant to protect existing shareholders from stampedes into and out of mutual funds.
Considering just how bad the bond markets got in March 2020, it’s stunning to read the full-throated defense of fixed-income mutual funds from Eric Pan, head of the Investment Company Institute, during a keynote address last month. “I question those who say that regulated funds must be regulated so aggressively that central bank intervention would never again be needed to provide liquidity support in the face of great economic shock,” he said. “It was the structure of the fixed-income markets — not the actions of funds — that was at the heart of the ensuing challenges.” He specifically warned against extending swing pricing to money-market funds, which Brainard suggested as an option.
Given that mutual funds are already on the defensive, it’s little surprise that their Washington advocate would balk at any suggestion that they’re risky or the main culprit for the chaos. While it’s certainly worth examining broader market structure issues, comparing fixed-income mutual funds with their ETF counterparts reveals why potential changes are needed. Bond ETFs provide liquidity throughout the trading day, and while they might trade at extreme discounts during periods of crisis, that’s effectively a form of swing pricing itself. Those who absolutely wanted out of the VanEck Vectors High Yield Muni ETF on March 18, 2020, had to sell at less than $43 a share, down from almost $66 two weeks earlier. Those who were willing to wait three weeks could have exited at $57. All the while, there was little to no forced selling.
Of course, that patience was rewarded in large part because of the Fed’s unprecedented intervention during that stretch. If the central bank doesn’t want to be in the business of bailing out open-end bond funds, then encouraging greater use of swing pricing might be a good place to start, even if it causes the industry to lose investors to ETFs. The current structure, which creates vicious cycles of inflows and outflows, is nowhere near as stable as it should be for an $18.2 trillion industry that my Bloomberg Intelligence colleague Eric Balchunas suggests might be the new “too big to fail.”
For better or worse, bond mutual funds came into existence before ETFs, when the corporate-debt and Treasury markets were only a fraction of their current sizes. If they want to stand a chance at outlasting them as well, something has to change. Brainard knows it. Yellen knows it. Nellie Liang, President Joe Biden’s pick to serve as the Treasury’s undersecretary for domestic finance, knows it. Rather than fighting any regulation and casting blame elsewhere, fixed-income fund managers should embrace sensible policies that provide a release valve in tumultuous times. It won’t doom them — and it might just save them.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.