Do mutual funds help transmit crises?

Claudio Raddatz and  Sergio Schmukler look at role of MFs in the crisis this paper. I have read the voxeu summary.

There are some interesting results:

The results suggest that, when there is a crisis in a country where funds invest:

  • Equity funds tend to amplify the shock by acting procyclically,
  • Bond funds, meanwhile, might help transmit crises across countries by acting (in relative terms) countercyclically, generating contagion effects to other countries in their portfolio. 

Why this difference?  Bond funds use cash as a buffer as they have difficulty selling bonds during crisis as they turn illiquid:

The findings also highlight some differences in the behaviour of bond and equity funds that indicate that the type of funds channelling capital flows into a country may matter for the behaviour of these flows. For instance, while in equity funds cash is used procyclically, being accumulated during crises, in bond funds cash is used more as a buffer, reducing the impact of redemptions on manager reallocations. This could imply that bond-fund managers have more difficulty buying and selling assets in markets that might be more illiquid, like some bond markets during crises, and thus use more cash to weather the shocks they face.

  Hmm

Other than this both investors and manager of MF exert sell-side pressure:

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.

In the case of the underlying investors, wealth effects (driven by shocks at home) seem to have a direct impact on how much they invest in other countries. Instead of investing more abroad when experiencing bad shocks at home, underlying investors retrench from the rest of the world and withdraw funds from international mutual funds.

  • When shocks are correlated across countries, like during the global or the European crises, investors do not act as deep-pocketed agents buying assets abroad at fire-sale prices.
  • The investor behaviour exerts pressure on managers, who need to react to this pressure as well as to shocks to returns (or valuation effects). 
Policy implications? Well don’t think shift to market based system will necessarily be for the better:

The findings have important policy implications. Some proposals suggest a shift from banks to a mutual-fund model to avoid runs and contagion effects.

  • This shift will not necessarily solve the problem that banks entail, since our results show that runs and contagion are possible even in equity funds.
  • Idiosyncratic risk and market discipline play only a limited role during crises and, thus, regulation based on those pillars would not entirely isolate financial systems from crises.
  • To the extent that open-ended structures constrain long-term arbitrage, there could be socially excessive open-ending.
  • The fact that shocks to the supply side of funds are important implies that providing liquidity at times of crisis might help stabilise markets and countries.

If instead crises were country specific with investors expecting unreasonable rates of returns, providing financing at times of crisis might fuel moral hazard.

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