A general hazard is that a portfolio manager inadvertently changes the risk makeup of the portfolio to meet shareholder redemptions. This is notably true when mutual funds see prolonged periods of shareholder redemptions, like the 16 weeks of outflows experienced by municipal bond mutual funds in 2022.
Portfolio managers may have to sell what they can instead of what they should. When redemptions hit, the first things to be sold are most often the reserve positions (increasing the average duration of the mutual fund).
After that, securities are sold (usually the most liquid and readily marketable). This action may release embedded capital gains. In my experience, no investor likes being hit with capital gains in a declining market.
As a result, the long-term impact is that the slope of the recovery line is much flatter than the slope of the decline line. So, if an investor loses 5% in the period of decline (all else equal), they may only recover 3%.
Let's look at the impact by risk factor. The significant risk elements in a mutual fund are duration and credit. Still, the same analysis can be applied to all the other risk factors in a mutual fund (convexity risk, pre-payment risk, de minimus risk, etc.).
The sale of reserves has the effect of lengthening the fund's duration and making it more susceptible to future price declines as rates continue to rise. The fund becomes a riskier asset than when the investor initially purchased it.
If the manager actively manages the fund's duration, they will likely have to sell securities or short some sort of derivative.
The securities chosen for sale will impact the credit risk of the existing mutual fund. If highly rated and the most liquid securities are sold (they may get the best-perceived price at the time), the fund will potentially take on more credit risk.
In dynamic interest rate environments like the one we’re in, investors must be aware of the changing risk parameters of their pooled investment vehicles like mutual funds. The actions of others (read: fund redemptions) are the leading cause of these changing risk characteristics and the release of embedded capital gains. Investors can avoid these pitfalls by using investment vehicles that allow for more personal control, like separately managed accounts.
If you would like a more in-depth discussion of this topic, please reach out to Chris or Sweta.
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