Monday, May 14, 2007

The Mutual Fund Run

There are about 8,000 mutual funds in the United States and 55,000 worldwide. Of those in the US, 4,600 were stock mutual funds. 55% of the money invested in mutual funds is invested in Stock Mutual funds (5 Trillion dollars). 48% of all of the Mutual Funds are in tax deferred accounts. Mutual funds owned 23% of all US publicly traded stocks for the year ending 2005. There is more info on this at

I am not really picking on all mutual funds just the open ended ones, the closed end ones look OK. The open ended funds are open to anyone and new shares will be issued to the investing buyer. There is a built in flaw with these funds. If the stock market turned bearish and started to drop drastically, things would start to happen. Your mutual fund portfolio would drop in value. At this point you have three choices; withdraw your funds, switch to a non stock portfolio with the fund, or do nothing. With withdrawal, you could face an early withdrawal penalty of 5% or as with the tax deferred accounts, an IRA penalty on top of that.

Notice that 52% of the investors have the option to withdraw without tax penalties. The rest probably have the option to switch from stock to money market funds. Here’s where things start to become unglued. The mutual stock fund facing redemptions has to sell stock for redemptions, and also for the transfers being made to money market funds.

The stock fund manager is sitting in his office wants to buy the market, everything is at a discount. What’s he being ordered to do? Raise cash! So what’s he about to do? Sell into a declining market. I just hope they don't try to sell the whole 23%.

There is an exception to this model and it is called a Closed End Mutual Fund. The managers of these funds don’t have to do anything when things get rough. Their fund’s shares trade like stocks. In a panic, you could sell your shares to another investor. It would not be uncommon for a closed end fund to trade for a 20% discount to the book value of the stocks it held in its portfolio. A great little shopping item, if you spot a panic. In this case you are buying a portfolio of stocks that has a fund manager without calls to raise cash to meet withdrawals.

The real disconnect that I see in the mutual fund market is the interest in the foreign funds. The Asian markets are touted as a "New Frontier." My jaw can't drop that low, I'm just too old. When Templeton suggested that market, the absurdity of the idea boggled my mind. Don't go there!

Foreign mutual funds in a panic could be dead meat. The natural instinct in foreign countries, in a panic, is to dump the local currency for U.S. dollars. The first thing that their government would do to stem the tide is to pass laws against repatriating the currency. In this case, you could cash in the foreign stock fund into local currency, but what good will that do, you can't convert it to US dollars? I'm not even touching on the corruption in third world Asian markets, Japan included.

So what happens if the stock market drops like a rock? The investors in these stock mutual funds are going to pull out of the fund or wish they had. This will force the money managers to sell into the abyss. In the 1930’s they called it “A run on the bank.” In 2001 it was called a 50% haircut. Get ready for the Mutual Fund Run and by the way, it's not a marathon!


Chuck Ponzi said...

One nit to pick about tax deferred accounts: You can sell a MF within an IRA without realizing the IRA penalty.

I own stocks... and have even day traded before within my IRA when the getting was good. IRAs have the same limitations as a normal brokerage account at most brokerages; with one exception, you can't withdraw the money until you're of retirement age without a penalty.

Chuck Ponzi

Anonymous said...

Why would some of these funds be interested in buying subprime lenders like Accredited Lending? It seems to me that these lenders cannont be salvaged. Is it because some of the people throwing these companies a lifeline are trying to make the price of the stock go up because they are already holding on to a lot of it?
I would like your input on this.

Jim in San Marcos said...

Hi Chuck

Looks like there is two ways to do an IRA. When I first started mine, I went to a Travelers and opened up an IRA. They sold the fund to someone else who I don't really care for.

This year I went to my bank and opened up an IRA. It looks like this approach gives me the option of switching anywhere without penalty.

So it looks like there are two approaches to an IRA. Does this sound right or have I crossed a few wires here?

Jim in San Marcos said...

Hi Anon

I don't think that the mutual funds would have much interest in acquiring sub prime lenders.

If the mutual fund is not in stock, it could be lending to these institutions indirectly. The fund could be loaning to a bank with good rate of return not caring what happens from there.