In case you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.
What Is Liquidity Risk?
The Investment Company Act of 1940 address two key concerns relating to liquidity risk. It stipulates that mutual funds have up to seven days to distribute sale proceeds to shareholders (although most do it the next business day). It also allows funds to only hold a maximum of 15% of fund assets in illiquid securities.
To learn more about the SEC’s new liquidity rules, click here.
Ways by Which Mutual Fund Houses Ensure Regular Liquidity
- Maintaining a cash position – Many funds keep a small portion of cash as part of the fund’s asset allocation. This cash is often used to fund daily transaction activity.
- Balancing buying and selling – Investors make continuous purchase and redemption requests. Funds manage new money coming in to offset redemption requests going out.
- Maturing bonds – As bond holdings in the fund mature, they get redeemed for cash.
- Reinvested dividends – All dividend and interest payments received go into the fund’s net asset pool.
Learn about how swing pricing is used in mutual funds by clicking here.
Types of Funds That Tend to Demonstrate Greater Liquidity Risk
Other asset classes, such as emerging markets equities, real estate and commodities, can experience similar issues if the supply and demand balance changes quickly.
To learn more about how a mutual fund’s NAV is calculated, click here.
Key Considerations for Investors
- Look for wide bid-ask spreads – If you want a quick and easy gauge of a fund’s liquidity risk, look at the bid-ask spread. A wider range indicates buyers need to pay a higher price and/or sellers need to accept a lower sale price. Either one can negatively impact an investment’s total return.
- Fluctuations in NAV – Since liquidity pressure makes an investment inherently more risky, be prepared to experience greater NAV changes.
- Potential for significant losses – As evidenced by the Third Avenue example, a severe liquidity crunch can result in massive losses in unusual cases. A severe imbalance of buyers and sellers could lead to wide disconnects between a security’s value and the value it’s trading for.
The Bottom Line
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