Plain-vanilla investment products such as mutual funds and exchange-traded-funds can pose financial stability risks, notes IMF report.

In its April 2015 report on “The Asset Management Industry and Financial Stability”, the IMF notes oversight of asset management industry should be strengthened, with better microprudential supervision of risks and through the adoption of macroprudential orientation.

Asset management industry intermediates $76 trillion assets

According to the IMF report, in advanced economies, the asset management industry has been playing an increasingly significant role in the financial system, especially through enhanced credit intermediation by bond funds. The report notes globally, the industry now intermediates assets amounting to $76 trillion, translating into 100% of world GDP and 40% of global financial assets:

Asset management industry's financial intermediation Mutual Funds

Touching upon the benefits of financial intermediation through asset management firms, the report notes it can provide financing to the real economy as a “spare tire” even when banks are distressed. While banks are predominantly financed with short-term debt, most investment funds issue shares, and end investors bear all investment risk:

Recent growth of investment vehicles Mutual Funds

The IMF report notes high leverage is mostly limited to hedge funds and private equity funds, which represent a small share of the industry. Hence the report notes, solvency risk is low in most cases.

However, the report emphasizes that the growth of the industry has given rise to concerns about potential risks. For instance, the assets under management of top AMCs are as large as those of the largest banks.

Risks in plain-vanilla mutual funds

The following table sets forth risk profiles of major investment vehicles:

Major investment vehicles Mutual Funds

The IMF report notes plain-vanilla mutual funds and ETFs which constitute the largest segment of the industry do not suffer much from the known vulnerabilities of hedge funds and money market funds. However, the report highlights that intermediation through plain-vanilla funds, is however, not risk free:

Unleveraged open-end funds Mutual Funds

The report notes easy redemption options can create run risks due to a first-mover advantage. Moreover, investors can have an incentive to exit faster than the others even without constant net asset value or guaranteed returns if the liquidation value of fund shares declines as investors wait longer to exit.

The IMF report also notes a large proportion of funds issue easily redeemable shares, and liquidity mismatches have been increasing:

Liquidity mismatches Mutual Funds

As elucidated in the following graph, client types, fees, and to some extent the market liquidity of assets and fund characteristics influence the sensitivity of fund flows to performance:

Liquidity risk and fund structures Mutual Funds

The report points out that the destabilization of prices in certain asset segments, particularly bonds, can affect other parts of the financial system through funding markets and balance sheet and collateral channels. The report notes funds managed by larger AMCs do not necessarily contribute more to systemic risk; investment focus appears to be relatively more important than size when gauging systemic risk.

The IMF report concludes that though these risks are not fundamentally new, their relevance has risen with structural changes in the financial sectors of advanced economies. The report has a few messages including enhanced liquidity rules, the definition of liquid assets, investment restrictions, and reporting and disclosure rules.

See full report below.