Polarity for Severe Redemption: Mutual Funds

The aftermath of the current financial crisis has been felt by many avenues of the financial world which theoretically should have done well as a consequence of the liquidity crunch. Rate cuts across the globe by various central banks were targeted at increasing liquidity and getting the money wheel rolling. But despite this, Bonds, Gilt Funds, Open Ended Mutual Funds etc. have all felt excessive redemption pressure.

Experts try and explain this phenomenon by various arguments but by far the most widely accepted explanation has been Herd Mentality which branches out of Behavioral Finance. It is a result of coordination failures between investors or their own beliefs that they try and find evidence for. This in turn reinforces the belief. So something that starts as a thought turns into fear and then belief, forcing the investor to act in a specific manner. Investors feel that other investors will withdraw their funds and a bank run begins. What follows is frenzy selling to try and secure cash. The worst thing is that this cash is then kept idle as savings and not as any other mode of investment. This stops the circular flow of money and adds to the liquidity crunch.

Mutual Funds in particular tend to face very high redemption pressure at such times due to their open ended feature and high degree of retail ownership. The redemption pressure in turn forces the fund managers to adjust their portfolios and enter into costly and unprofitable trades, thus damaging the overall returns of the fund. Most Mutual Funds try and diversify a major portion of the portfolio into midcap or small cap stocks which makes them illiquid to a large extent. In such a situation, this problem of illiquidity of the stocks in the portfolio makes it difficult to execute large trades without adverse price impact. This phenomenon is referred to as Forced Trading.

Posted by Rahul