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Why mutual funds could face a liquidity squeeze in the next big sell off

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Contrary to current expert commentary mutual funds are more at risk of being at the heart of any liquidity crisis in investment markets in the next downturn than ETFs, with their archaic structures and unclear pricing leaving them vulnerable, HANetf founder Hector McNeil has said.

While much has been made of the supposed risks building in Exchange Traded Funds, particularly how they may exacerbate any sell-off if that materialises, McNeil has said the real danger for investors is in mutual funds, where products could be gated in the event of a serious downturn.

“One only has to look back to events so far this year, or when there was a run on property funds in 2008, to see where the heart of any crisis could manifest itself,” he said. “There is the common excuse that people will sell ETFs rather than mutual funds because it is easier to do so, but the reality is that there are a number of technical trading mechanisms for ETFs which reduce, rather than exacerbate, potential liquidity issues.”

These include the ability of an ETF’s authorised participants/market makers (typically big banks or professional brokerages) to create and redeem shares as and when needed. AP’s can also aggregate buys and sells throughout the day for an ETF, reducing the friction (and downside impact) to the existing shareholders, unlike a mutual fund which cannot do so.

This is not to say that ETFs are not impacted by the underlying liquidity of the asset class they are linked to. However, the actual structure of ETFs means that buyers and sellers can still get an accurate picture of the available liquidity in an ETF every day, unlike a mutual fund, where this is yet another unknown on top of whatever issues there may be at an asset class level.

Also, ETFs that track an index usually have a liquidity screen that only includes stocks that meet a minimum liquidity measure.

McNeil, who with Nik Bienkowski recently founded HANetf – Europe’s first independent full service third-party provider of UCITS ETFs – added:

“The Bloomberg implied liquidity function for ETFs is incredibly useful and goes a long way to tackling fears over ETFs ceasing up in times of stress. This is in stark contrast to mutual funds, and the question investors should be asking more and more is why they continue to buy and sell a product without knowing the real price they pay for it. Indeed, the mutual fund market is one of the few things in existence where you buy or sell something without knowing the price you will be paying or the money you will be receiving back and you have to sell it back to the person you bought it from.”

Further reading for Armchair Traders:

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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