Be ready for downside volatility in investment funds

This is notable because there has been a strong tendency among investors to load up on the fixed-income asset class, perceived as being safer and more stable than equities, since the financial crisis.

“In normal times, funds hold sufficient cash buffers to cover investor redemptions,” the BoC report explained. “However, large redemptions may force funds to sell their assets — and the lack of market liquidity could intensify price movements.”

Liquidity in fixed-income markets has become less reliable — in both government and corporate bond sectors — and could “deteriorate rapidly during a financial stress event,” the BoC report noted.

As a result of a decline in market liquidity, there is a risk that the selling process could be “disorderly,” leading to significant investor losses and reduced investor confidence.

“While volatility may be gradually returning to more normal levels as a result of fundamental factors, a deterioration in market liquidity could amplify volatility if a large number of investors tried to unwind their positions in the same manner at the same time,” the BoC report said.

Foreign investors also hold a larger share of the Canadian federal government bond market than in the past — and some kind of shock in their home markets could be the catalyst for a sell-off in these Canadian bonds, the BoC report warned.

The BoC report also said that increasing valuations across many asset classes in Canada — such as in corporate bonds and equities — suggest an ongoing search for higher returns by both domestic and foreign investors and that they’re taking on greater credit and liquidity risks in their quest for returns.

“A buildup of higher-risk positions, especially if accompanied by leverage, could lead to systemic stress if there were a sharp drop in asset prices,” the BoC report said. “While there is limited evidence of highly leveraged investors, reduced levels of market liquidity, particularly in fixed-income markets, could cause difficulties in unwinding large positions and could amplify price changes, resulting in an increase in volatility and sizable losses for investors.”

The investor base in fixed-income markets has shifted to include more mutual funds and exchange-traded funds (ETFs) in the corporate bond market, bringing a large swath of retail investors into these markets along with institutional investors, the BoC report said.

However, the good news is that the BoC’s analysis suggests that “Canadian open-end mutual funds hold adequate amounts of cash buffers, which coupled with low leverage, pose a limited risk of large sell-offs.”

ETFs, however, do not hold cash buffers and instead buy and sell securities to track a specified index.

The BoC report also stated that a large share of Government of Canada bonds is held by “official investors,” such as foreign reserve managers, who are less likely to rapidly reduce their holdings of Canada bonds in response to shocks.

Also on a positive note, the danger to Canadian mutual funds and the problems that could emanate from the broader financial sector are currently limited, the BoC report said. This is because most funds hold an adequate amount of cash to cover potential redemptions given the underlying liquidity of their investments and that these funds also seem to have a stable investment base.

In addition, securities legislation restricts the degree of leverage and derivatives exposure in funds. Even the largest funds in Canada are not dominant players in the securities markets, the BoC report said.

In 2013, the average fixed-income fund held about 10% of its assets under management (AUM) in cash equivalents, while only 5% of fixed-income funds experienced monthly outflows greater than 6% of their AUM, the BoC report said. There was no mention of introducing requirements for funds to hold specified amounts of cash to meet redemptions.

No single mutual fund is large enough to cause systemic stress directly, the BoC report said. Only six Canadian funds — including one equity fund, two fixed-income funds and three balanced funds — have more than $10 billion in AUM. Four of these funds hold mainly equities and account for less than 1% of the total market capitalization of the Toronto Stock Exchange.

Moreover, these funds are not dominant players relative to other funds in their categories. For example, the five largest Canadian equity, balanced and fixed-income mutual funds hold 9%, 20% and 21% of fund AUM in their respective categories.