IMF warns funds with illiquid assets pose risk to financial stability

The IMF has warned that a surge of outflows from funds allowing frequent investor withdrawals but holding hard-to-sell assets could amplify market stress and “potentially undermine the stability of the financial system”.

Withdrawals from open-ended bond funds have increased in recent months, the IMF noted, and another shock could “trigger further outflows”, with a mismatch between redemptions and illiquid holdings posing a “major potential vulnerability”.

The Washington-based international body singled out less frequently traded securities such as corporate bonds, certain emerging market assets and real estate as most at risk during periods of market volatility when investors can move to sell in unison.

“Pressures from these investor runs could force funds to sell assets quickly, which would further depress valuations. That in turn would amplify the impact of the initial shock and potentially undermine the stability of the financial system,” the IMF wrote in a blog post on Tuesday.

A number of UK property funds moved on Monday to limit withdrawals, in a sign of how strategies based on harder-to-trade assets struggle when convulsing equity and bond markets compel investors to rush for the exit.

Open-ended funds have grown to manage around $41tn in assets, or one-fifth of holdings managed by the financial sector outside of banks, in the past two years. Most of these funds invest in relatively easy to trade assets such as stocks and bonds, but the desire to allow investors to diversify has led to the expansion of funds with exposures to less liquid holdings.

These dynamics can also be damaging to emerging markets, where liquidity already tends to be weaker even in more stable periods.

“A decline in the liquidity of funds domiciled in advanced economies can have significant cross-border spillover effects and increase the return volatility of emerging market corporate bonds,” the IMF said.

Concerns about open-ended funds are not new. Property funds came under fire in 2016 and again in 2020 when the respective shocks of the Brexit vote and the outbreak of the pandemic forced a number of them to gate, locking in tens of billions of pounds of investor funds.

In the aftermath of the UK’s vote to leave the EU, investors looked to pull out of the funds. Property vehicles holding £15bn, run by managers including Standard Life, Aviva and M&G, suspended trading when faced with a wave of redemption requests.

Funds were also “gated” in March 2020, trapping more than £20bn, when the disruption caused by coronavirus left property valuers unable to accurately price assets.

The UK’s Financial Conduct Authority requires fund managers to consider suspending property funds in extreme market conditions to allow an orderly sell-off of assets.