Mutual funds are intended to be mom-and-pop financial products whose investments can be sold off quickly. The funds were never meant to pile into markets where trades take weeks to complete.
Some mutual funds, however, have lately been making bets that might be hard to get out of, especially in difficult market conditions.
The stampede into investments that can be difficult to exit has regulators increasingly concerned. On Thursday, Mary Jo White, the chairwoman of the Securities and Exchange Commission, told a conference organized by The New York Times/DealBook that the agency was undertaking a comprehensive review of the mutual fund sector. One of the review’s major objectives is to assess whether some mutual funds are loading up on investments that would take too long to unwind.
“A fund that does not manage liquidity risk in its portfolio could have difficulty meeting redemptions if it came under stress,” Ms. White said.
On Wall Street, liquidity refers to the ease at which a trade can get done for a reasonable price. An illiquid market is one where trades may be infrequent or take a long time to complete. Mutual funds face caps on how many illiquid assets they can hold. The fear is that funds that hold hard-to-sell assets might get caught out in times of crisis. Crucially, the funds may not be able to unwind their bets at a quick enough pace to raise the cash that would be needed to make timely payments to withdrawing customers.
Ms. White also said Thursday that the agency was considering whether to update its liquidity standards for mutual funds. The current rules that govern mutual funds and illiquid assets, which are more than 20 years old, may need an overhaul after the funds have expanded into new investments and markets.
Certain types of mutual funds might come in for particular scrutiny in the review, like those that deploy hedge fund tactics in their investing.
But Ms. White’s remarks on liquidity may have significant consequences for a type of mutual fund that has soared in size since the financial crisis of 2008. These are funds that invest mostly in leveraged loans, the Wall Street name for bank loans to companies with low credit ratings.
As interest rates have fallen to record lows, the market for leveraged loans has swelled. The companies like to borrow cheaply with the loans, and investors like the debt because it often has higher yields than other types of investments. Mutual funds and exchanged-traded funds that bet primarily on leveraged loans now have $113 billion of assets, up from around $20 billion before the financial crisis of 2008, according to data from Lipper.
The leveraged loan mutual funds face a big headache when it comes to trading the debt. On average, investors in the debt have to wait two weeks — and sometimes a lot more — to actually collect the cash from selling the loans. For stocks and bonds, that process is usually completed in no more than three days.
“In a very stressed market environment, there exists the possibility that fund managers might not be able to receive the proceeds to pay off investors in their funds,” said Stephen Tu, an analyst with Moody’s Investors Service who covers mutual fund companies.
Prominent asset management firms, like Fidelity, Oppenheimer, Invesco and Eaton Vance, manage some of the largest leveraged loan funds. The fund firms are often upfront about the risks of the leveraged loan market. The public documents for their funds emphasize that the leveraged loan market can be illiquid. In addition, the funds may have access to credit lines that they can draw on to help finance customer withdrawals in stressed periods. And the fund companies also point out that leveraged loan funds have coped with sizable customer withdrawals this year.
Joseph Welsh, manager of the Oppenheimer Senior Floating Rate Fund, noted that funds for retail investors have had $24 billion of outflows since April. “It was all withdrawn totally orderly,” he said.
Still, the last few months have not been especially difficult for the debt markets or the wider economy. The leveraged loan funds were much smaller in 2008, the last time that markets crashed and dried up. And analysts like Mr. Tu of Moody’s wonder how the funds might now deal with an inundation of customer withdrawals.
A fund can place an order to sell a loan with a Wall Street firm immediately. But it takes much longer for the seller to collect the cash and transfer ownership of the loan — a crucial process known as “settlement” on Wall Street. In the median leveraged loan trade, settlement takes around 14 days, according to data from the Loan Syndications and Trading Association, an industry group.
One reason it takes so long is that the banks that originally arranged the loan have to register the change in ownership of the debt. And the banks sometimes go to the borrowing firm — which may not want certain investors holding its debt — to approve the change in ownership.
The Securities and Exchange Commission has long had qualms about mutual funds holding illiquid assets. A rule from 1992, for instance, says that mutual funds cannot have more than 15 percent of their holdings in illiquid assets. And the rule goes on to define illiquid assets as those that “may not be sold or disposed of in the ordinary course of business within seven days at approximately the value at which the mutual fund has valued the investment on its books.” Given that it can take far longer than seven days for a leveraged loan trade to settle, mutual funds would appear to face tight restrictions on how many loans they can hold.
But another commission regulation, from 1969, defines a sale in a way that has effectively made the loans’ long settlement periods a nonissue. This rule says that a sale takes place merely when the seller and buyer of an asset have a written contract for the transaction. As a result, when it comes to defining illiquidity, settlement doesn’t have to be complete. Instead, the seller merely has to have a written confirmation that the trade has been agreed to. “We consider sales happening on the trade date not on the settlement date,” Mr. Welsh, the fund manager at Oppenheimer, said.
But Mr. Tu contends that actually getting hold of cash through settlement is important in turbulent times. The exiting customers of a leveraged loan fund might want their money, but the fund might not be able to raise it in a timely manner in a market where settlement can take two weeks or more.
“The key thing really is the settlement,” he said.
And in a sign that the commission is thinking about the exact time it takes funds to pay their customers, Ms. White on Thursday said, “Of course, mutual funds must pay shareholders their redemption proceeds within seven days of any request.”
The mutual fund industry will now be waiting nervously for the results of the commission’s review.
Critics of leveraged loan funds say it makes sense to define an illiquid asset as any asset that does not complete settlement within seven days. If the agency were to adopt that definition after its review, many of the loan funds would most likely find that they had far more than 15 percent of their holdings in illiquid loans. And there may be precedent with the S.E.C. itself for that broader definition.
In a 1986 rule, the agency seemed to emphasize the need to actually receive timely payment in a definition of illiquid assets. It stated, “A security is considered illiquid if a fund cannot receive the amount at which it values the instrument within seven days.