February 15, 2016
What we’re reading this week
Mutual Fund Fire Sales
Investors and regulators the world over are concerned about mutual fund fire sales and whether such fire sales represent a systemic risk to the financial markets. Recently the New York Fed concluded that they do in fact. A fire sale can occur when the asset value or share price of a mutual fund declines due to underlying positions (stock, bonds, or both) declining. These initial declines trigger additional redemptions of the mutual fund or sales which drive the share price down further. The New York Fed cites three major factors contributing to the heightened risk posed by mutual fund “spillover vulnerability.” One, asset growth. As mutual funds have grown in popularity their ability to impact the market has also increased. A larger asset value coupled with hyper concentration in certain asset classes (bond funds particularly) means that funds are especially sensitive to jumpy investor behavior and the market itself is more sensitive to mutual fund behavior. Two, investor behavior. Since the financial crisis, individual investors have become more skittish. Investors are demonstrating a higher degree of sensitivity to declines in stock prices, much quicker to pull the trigger and sell. The third factor is “illiquidity concentration.” Especially large mutual funds may have some or a lot (bond funds) of their assets held in illiquid assets. Consider bond funds in particular. When an investor sells shares of a bond fund, that money has to come from somewhere. It comes from bond investments when there isn’t enough cash on hand to cover redemptions. If I $10 invest in ABC Bond Fund and the fund has 9 other investors, all having invested $10, the fund is worth $100. The fund manager then invests our money in a bond trading at par, or $100 (for this example please ignore fund expenses, 12-b1 fees, trading costs, and bond markups). The fed then raises interest rates which causes bond prices to decline. Let’s say the bond is now worth $84 and my initial investment is worth $8.40. If the fund managers hold this investment until maturity the investors will receive their initial investment back ($10) plus any dividends paid during that timeframe. However if I get scared and sell, the fund managers are forced to realize that loss and sell the bond. This creates further price declines and may trigger more losses. As Josh Brown at the Reformed Broker points out, “Concentration of illiquid investments at funds where shareholder performance sensitivity is high means a lot more whippy action to come until either something really bad happens or people calm the hell down.”
Should Google Buy AIG
Citigroup has an “audacious” idea: Google’s parent company, Alphabet, should buy AIG and turn it in to a laboratory for innovation. “Money Stuff” author, Matt Levine, pointed out that one of Google’s objectives is to solve the problem of human mortality which, if successful, would turn AIG’s life insurance business into pure profit. There would be drawbacks to the annuity business though…
Last week former pharmaceutical executive, Martin Shkreli offered to buy Kanye West’s new album for $10 million. At the time I found the idea funny but Kanye has since come forward with a very public appeal for money going so far as to ask Mark Zuckerberg for a $1 billion investment into “Kanye West Ideas.” Earlier Shkreli gained notoriety for purchasing an unreleased Wu-Tang Clan album for $2 Million. In his offer to Kanye, Shkreli stated it “is not subject to a financing condition and I have discussed this offer with several investment banks and counsel which would assist me in this acquisition.” I really hope that’s true, as I love the idea of a banker discussing this with the financing committee.
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