Vulnerable Asset Management? The Case of Mutual Funds
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1 Vulnerable Asset Management? The Case of Mutual Funds Christoph Fricke 1 Daniel Fricke 2,3,4 1 Deutsche Bundesbank christoph.fricke@bundesbank.de 2 University College London 3 London School of Economics, Systemic Risk Centre 4 Saïd Business School, Oxford d.fricke@ucl.ac.uk 26 th September2017 The views expressed here are the authors and do not necessarily represent the views of Deutsche Bundesbank or the Eurosystem. Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
2 Motivation Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
3 Motivation - Are funds systemic? History: Role of portfolio insurers in the market crash of 1987 LTCM s asset fire-sales in 1998 and followed bailout Regulators view: (FSB, ESRB) Identifying structural sources of vulnerabilities in the asset management sector Vulnerabilites due to asset liquidations forced by liquidity transformation and leverage Identify NBNI-GSIFIs to develop an adequate regulatory framework Industry view: Tight leverage regulation of mutual funds Microprudential regulation mitigates systemic risk in the fund sector Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
4 Motivation - Are funds systemic? Academia: Evidence on fragility: Goldstein et al. (2015) Funding fragility of bond funds might cause fire-sales Zeng (2016) Inherent run incentives in the fund sector Systemic risk: IMF (2015) Fund style and size related to fund s contribution to systemic risk (CoVaR) Investment style more important than size Equity funds contribute more to systemic risk than bond funds Danielsson & Zigrand (2015) Focusing on negative externalities stemming from funds Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
5 Contribution - Macroprudential stress test Contribution: macroprudential stress-test on systemic risk in the mutual fund sector incorporation of funding fragility overcomes industry s leverage-argument fire-sales as a source of systemic risk estimation of systemic risk contribution at fund level addresses the negative externalities (Danielsson & Zigrand, 2015) reveal indicators potentially useful for regulators size portfolio diversification portfolio (il)liquidity Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
6 Measuring vulnerabilities (Extending Greenwood, Landier, and Thesmar (2015)) Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
7 Model Fund balance sheet: Assets under management: A Asset portfolio weights: M Fund shares (Equity) : E Credit lines (Leverage): D Leverage-ratio: B = D E 4-Step approach: 1 Initial shock on the value of funds asset holdings. 2 Investors withdraw some of their money (flow-performance relationship). 3 Asset liquidation decision of funds for liquidity generation and leverage targeting. 4 Asset liquidations have price impact. Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
8 4-step stress-test: Illustration Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
9 Step 1: Initial Shock Asset price return Assume asset price returns F 1 Obtain funds portfolio returns: R 1 = MF 1 with R 1 being a (N x 1) vector. Funds updated total assets A 1 = A 0 (1 + R 1 ) the corresponding equity and debt position E 1 = E 0 + A 0 R 1 D 1 = D 0 Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
10 Step 2: Response on the funding side Funding providers response to asset price shocks: Shareholders - Flow-Performance-relationship: Creditors - Credit line adjustments: E 2 E 1 = γ E R 1, (1) D 2 = γ D R 1 D 1 = γ D R 1 D 0, (2) With these additional adjustments on the liability side of the balance sheet, updated equity and debt can be written as E 2 = E 1 (1 + γ E R 1 ), (3) and D 2 = D 1 (1 + γ D R 1 ). (4) Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
11 Incorporating fire sale dynamics Step 3: Total amount of assets to be liquidated: φ = γ E M E 1 R }{{} 1 + γ D M D 1 R }{{} 1 + M A 0 B R }{{} 2, (5) Net inflow of equity Net inflow of debt Leverage targeting Step 4: Asset fire-sales generate linear price impact: where L is the matrix of price impact ratios F 3 = L φ, (6) Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
12 Measuring Vulnerability Exposures Definition Aggregated Vulnerability (AV ): dollar effect of shock F 1 on fund assets through fire-sales Here, standardized by funds equity position, E 0 ( [Γ 1 N AV A 0MLM E E 1 + Γ D ] D 1 R1 + A 0 B R ) 2 =. (7) E 0 with A 0 MLM as the liquidity-weighted asset holdings. Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
13 Measuring Vulnerability Exposures Definition Systemicness (S): fund s individual contribution to the aggregated vulnerability ( [Γ E E 1 + Γ D D 1 ] R1 + A 0 B R 2 ) where N i 1 N A 0MLM δ i δ i S i = S i = AV. E 0, (8) Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
14 Measuring Vulnerability Exposures Definition Indirect Vulnerability (IV ): fund s indirect vulnerability with respect to shock F 1 as the impact of the shock on its equity through the deleveraging of other funds IV i = δ i A 0MLM ( [Γ E E 1 + Γ D D 1 ] R1 + A 0 B R 2 ) E i,i. (9) Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
15 Model Application Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
16 Data U.S. domestic equity funds Source: CRSP Survivor-Bias-Free Mutual Fund Database Sample: 2003-Q1 and 2014-Q4 Sample Size: 7,914 unique funds and 98,054 fund-quarter observations Balance sheet: Portfolio Weights M: asset holdings at a quarterly basis Size: sum of asset holdings (assets under management) Flows: Flow i,t = TNA i,t TNA i,t 1 (1+Return i,t ) TNA i,t 1 Leverage: Maximum allowed leverage (Investment Company Act of 1940) maximum value of D A is 0.33 B = 0.5 Equity: E = A D Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
17 Parameter: Flow-Performance Relationship return of -1% -0.30% fund share redemption Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
18 Data Price Impact Asset liquidity Source: CRSP-Compustat Measure: Amihud ratio Amihud k,d = Return k,d DVolume k,d (10) PriceImpact k,t = 1 D k,t Amihudk,d, (11) Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
19 Price Impact Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
20 Stress scenario Input parameters: Asset price shock Initial shock of -5% on all assets; F 1 = price impact scenarios 1 Price impact time-varying and asset-specific. 2 Price impact asset-specific but constant over time. 3 Homogeneous price impact of for all assets in all quarters (the typical value of the equal-weighted average price impact). Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
21 Aggregated Vulnerabilities - Scenario 1 Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
22 Aggregated Vulnerabilities - Scenario 1 - Fund split Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
23 Aggregated Vulnerabilities - Scenario 2 Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
24 Aggregated Vulnerabilities - Scenario 3 Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
25 Vulnerability Determinants Alternative measures Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
26 Vulnerabilities according to liquidity assumptions Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
27 Implications Policy implications Microprudential: Focus on resilience of a fund to a market-wide shock Indirect vulnerability (IV) larger and more diversified funds more robust to other funds deleveraging Macroprudential: Concerned with negative externalities imposed by funds (Danielsson & Zigrand, 2015) Systemicness (S) larger and more diversified funds contribute more to the vulnerabilities in the fund sector Commonality: Illiquidity contributes to both IV & S Better understanding of liquidity transformation in the fund sector Improve monitoring of funds liquidity profiles Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
28 Questions & Comments Christoph Fricke & Daniel Fricke Vulnerable Asset Management? 26 th September / 28
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