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IMF report examines mutual funds and ETFs and calls for stronger oversight


A new report from the IMF entitled 'The Asset Management Industry and Financial Stability' examines what risks so-called plain vanilla mutual funds and ETFs pose to financial stability.

The report acknowledges that greater risk lies with leveraged products such as hedge funds and money market funds. “However, opinions are divided about the nature and magnitude of any associated risks from less leveraged, “plain-vanilla” investment products such as mutual funds and exchange-traded funds” the report says.
“Financial intermediation through asset management firms has many benefits. It helps investors diversify their assets more easily and can provide financing to the real economy as a “spare tire” even when banks are distressed. The industry also has various advantages over banks from a financial stability point of view” the report finds.
“Nonetheless, concerns about potential financial stability risks posed by the asset management industry have increased recently as a result of that sector’s growth and of structural changes in financial systems. Bond funds have grown significantly, funds have been investing in less liquid assets, and the volume of investment products offered to the general public in advanced economies has expanded substantially. “
According to the report, opinions are divided about the nature and magnitude of any associated risks from less leveraged, “plain-vanilla” investment products such as mutual funds and exchange-traded funds.
 “In principle, even these plain-vanilla funds can pose financial stability risks. The delegation of day-to-day portfolio management introduces incentive problems between end investors and portfolio managers, which can encourage destabilising behaviour and amplify shocks. Easy redemption options and the presence of a “first-mover” advantage can create risks of a run, and the resulting price dynamics can spread to other parts of the financial system through funding markets and balance sheet and collateral channels.”
The report states that empirical analysis finds evidence for many of these risk-creating mechanisms, although their importance varies across asset markets. “Mutual fund investments appear to affect asset price dynamics, at least in less liquid markets. Various factors, such as certain fund share pricing rules, create a first-mover advantage, particularly for funds with high liquidity mismatches. Furthermore, incentive problems matter: herding among portfolio managers is prevalent and increasing.”
The report finds that oversight of the industry should be strengthened, with better microprudential supervision of risks and through the adoption of a macroprudential orientation. “Securities regulators should shift to a more hands-on supervisory model, supported by global standards on supervision and better data and risk indicators. The roles and adequacy of existing risk management tools, including liquidity requirements, fees, and fund share pricing rules, should be re-examined, taking into account the industry’s role in systemic risk and the diversity of its products.”

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