Mitigating Run Risk And Managing Portfolio Leverage In Investment Management

Run Risk in Mutual Funds

1. What factors might provide an incentive to an asset manager (e.g., a mutual fund or hedge fund manager) to increase the risk (systematic and/or idiosyncratic) of her portfolio? Consider both the incentives provided by the compensation contract and those potentially induced by the relationship between the performance of the fund and flows into and out of the fund.

2. As we saw during the recent financial crisis of 2007-­?08, money market mutual funds that attempt to keep a fixed $1 price at which investors can redeem their investments at the end of any day are potentially subject to “runs” (similar to classical bank runs). Why does this run risk exist? What different types of potential regulations could mitigate this run risk (consider the actual regulations that were implemented but also other possible regulations to achieve the same goal)? What regulatory policy would you recommend?

3. Open–?end mutual funds may also be subject to run risk. Read the commentary on this Issue by Cecchetti and Schoenholtz at What do they identify as the problem? Do you agree that it is a problem? What do they suggest as a solution? Do you agree that their proposal is a viable solution to this problem?

4. Consider a hedge fund that raises $10 million in capital and levers this amount 5 to 1 for investment purposes. In other words, they borrow an additional $40 million at an assumed Interest cost equal to the risk–?free rate, and buy a total of $50 million of investments. Define the leverage ratio as (total assets/equity capital), which equals 5 = 50/10 in this case.

There are various factors that might induce the asset manager to increase the risk of his portfolio management.

• The foremost that might affect the risk-taking capability of the managers is the fact that the market is performing well, particularly the stock in which they are dealing. It is important that managers must have through knowledge of the market and should have the feel of it(YUAN, 2018). On analyzing the history, they can take decision whether they want to invest in the funds or not. Based on the same they can increase their level of risk.
• The market is captured by high net worth individuals that invest in the funds, in a manner that the liquidity factor does not affect them, in those cases they provide high rate of return through the compensation contracts and in that cases the managers are induced to invest in risky bonds. They have the privilege to experiment in these cases(Maynard, 2017).
• The overall movement of fund also affects the market a lot, and the asset managers needs to understand the same. They have the option to invest in large number of funds and various type of securities, a combination of different securities leads to a portfolio. In those cases, it becomes important to see in which funds they can invest more and vice versa, based on that they can increase the level of risk undertaken. The main aim should be to achieve stability, some assets will generate more return and vice versa(Kusolpalalert, 2018).

Run risk occurs when people have doubt on the solvency of the mutual funds, and withdraws the funds that they have, leading to actual situation where the funds gets insolvent and sometimes they don’t have so much funds to support the withdrawals. This is known as run risk and the same happens in Banks also. After the financial crisis 2007-2008, the investors had a option to redeem their investments at $1, at the end to any day, subject to potential run risk. This run risk existed because during that time the market was not doing well, and therefore people had a fear of losing on their investments, thus there was a situation where there was a chance of the mutual funds becoming insolvent and thus accelerated by the same people withdrew their investments from such funds (Anon., 2017).

Regulatory Policies to Mitigate Run Risk

Potential measures that can help in mitigation of the risk involves:

• Forming of policies that can provide assurance to the investors about the flow of funds and for that it is important that they should provide appropriate information to the investors, so that they don’t withdraw their money fearing that the hedge funds might become insolvent.
• The hedge fund managers can consider increasing the total charges of redemption so that people would be discouraged to redeem their money in this time of financial crisis(Maynard, 2017).
• Investor should be encouraged to invest in such funds in which the return is more stable and risk is low, so that when these are channelized the chances of insolvency are as low as possible.
• The managers should try to follow more tired and tested routes for channelizing the flow of money that will earn stable returns to the investor and reduce the run risk that is faced by such financial institutions(Chariri, 2017).

The most recommended policy would be to reduce the investment in more diversified portfolio and following tried and tested routes that would help in reducing the risk and that will reduce the chances of insolvency that the banks might face in any possible way. This would be the best way to reduce the errors of run risk and provide adequate return to the investors and promote them not to redeem their funds.

The main problem that they have identified are that popular investment assets offer liquidity to the investors when the underlying assets are not liquid. This causes a problem at the time of redemption of these funds. There are chances that the fund managers can sell of these assets without a larger liquidity premium to fulfil the redemption, but this may not be the case always. Also, when the investor makes early exit from the portfolio, then the managers have to adjust the portfolio accordingly, and this might cause pressure on the remaining shareholders who are left in the system. There is a risk of run that arises because of the first mover advantage (Abbott & Kantor, 2017).

Yes, this is indeed a problem for the both the investors and the managers who must manage the risk of low liquidity while adjusting the portfolio when they end up fulfilling the withdrawal needs to the first exit investors. This is not correct for the people who are left behind in the portfolio as they have to deal with low cost and less liquidity (Maynard, 2017).

The potential solution of the same would be to find an alternative to these open-ended funds and look for such investment options that reduces the run risk and in which the option of redemption is as less as possible. The authors suggested that people should convert these open ended mutual funds into exchange traded funds. Exchange traded funds are hybrids between open ended mutual funds and close ended mutual funds. So this helps in reducing the systematic risks that are associated with open ended mutual funds, as the level of illiquid assets reduces by the use of the same (Alexander, 2016). A new class of participants can be introduced known as  “authorized participants” (APs), that would have the right to create ETFs new shares and redeem the old one. This would in a way help to maintain the liquidity in the system.

Open-End Funds and Run Risk

The solution is potentially good, but the only point of concern is that investors fails to understand that there is no guarantee of liquidity no matter how much the mutual fund be secure or what measures are undertaken, there is an underlying risk that will always prevail. This is because nobody knows how the market will function and thus it becomes necessary to invest in such funds where the risk is considerably low.

If (in excess of the risk–?free rate) on the portfolio is –?10%, and the leverage ratio is 5, the increase in return the shareholder would be (10%/5 = 2%)

If the monthly volatility of the portfolio is 2%, and the return on the same in excess of free rate is -10%, then the volatility of the interest to the investor would be 10%/2% = 5%

If the monthly volatility of the excess return on the portfolio is 10%, the expected monthly excess return on the portfolio is 2%, and excess returns are normally distributed, the chances of getting a return bad enough would be 0.02%. This is based on the Sharpe ratio, that covers the volatility of the portfolio with relation to the return that is earned by the portfolio and the investor. The formula for Sharpe ratio would be

(Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return

= 2%/10% = 0.02%

Since there are no assets left to repay the borrowings at the end, the leverage ratio at the end of the month would be -10%, if the excess return on the portfolio is 10%. This is because there are no funds to repay the borrowings, so the volatility of the portfolio would affect the returns that the investor earns in equal measures. This is because in case the company goes into liquidation, there will be no assets left to repay the investors, this will expose the investors to more risk and thus they will be affected in equal measures.

Rebalancing is a process by which the weights of the portfolio are resigned to stabilize the portfolio and keep a check on the associated risk elements. Dynamic rebalancing helps to keep the portfolio close to their targets by managing the inflow and outflow of cash. In case the managers sell of their holdings when the prices fall, there will be a large outflow of cash and as the market has fallen there may not be potential investors available who would be ready to invest in the portfolio. Thus it is important that opting for rebalancing the hedger managers should study the market and then take the decision accordingly (Chiapello, 2017).

References

Abbott, M. & Kantor, A., 2017. Fair Value Measurement and Mandated Accounting Changes: The Case of the Victorian Rail Track Corporation. Australian accounting Review.

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Anon., 2017. Explaining auditors’ propensity to issue going-concern opinions in Australia after the global financial crisis. Accunting and Finance, pp. Carson,E;Fargher,N;Zhang,Y;.

Chariri, A., 2017. FINANCIAL REPORTING PRACTICE AS A RITUAL: UNDERSTANDING ACCOUNTING WITHIN INSTITUTIONAL FRAMEWORK. Journal of Economics, Business and Accountancy, 14(1).

Chiapello, E., 2017. Critical accounting research and neoliberalism. Critical Perspectives on Accounting, Volume 43, pp. 47-64.

Kusolpalalert, A., 2018. The relationships of financial assets in financial markets during recovery period and financial crisis. AU Journal of Management, 11(1).

Maynard, J., 2017. Financial accounting reporting and analysis. second ed. United Kingdom: Oxford University Press.

YUAN, T., 2018. The Prospect for RMB Becoming One of the Two Center Currencies of the Dual-Center Global Financial System. The Dual-Center Global Financial System, Issue 1, pp. 83-91.