In the face of intense market stress, mutual fund managers tend to prioritize liquidity by dumping their least liquid assets first, according to new research from a finance professor at York University’s Schulich School of Business.
In a new paper — slated to be published in the academic journal Management Science — Aleksandra Rzeźnik, assistant professor of finance at Schulich, examined the behaviour of fund managers when they are confronted with rising redemptions and volatile markets.
Her research is based on data from U.S. equity mutual funds between 1998 and 2019. She found that managers follow a liquidity “pecking order” — selling off their most illiquid assets first — which impacts the cost of liquidity and the returns generated by providing liquidity.
According to the paper, the relative liquidity of a stock within a fund’s portfolio is a key factor in determining the order of stocks that managers sell off — favouring the pursuit of liquidity over maintaining the portfolio’s composition.
“When faced with uncertainty and investor outflows, fund managers tend to prioritize liquidity preservation. This behaviour is not random — it follows a systematic pattern where the least liquid assets are sold off first, which has important implications for the market price of liquidity,” Rzeźnik said in a release.
“[T]he pricing mechanism used by open-end mutual funds not only generates a first-mover advantage among their investors that amplifies the impact of negative shocks, especially during market-wide stress, but also spills over onto the market price of liquidity and contributes to its variation over time,” the paper said.
Additionally, the paper finds that funds that are highly exposed to potential liquidity spirals are particularly vulnerable during periods of market stress.
“These funds adjust their portfolios more aggressively, intensifying the overall market response,” it noted.
Specifically, it finds that funds’ responses to uncertainty are stronger when their portfolios are less liquid, their flows are more sensitive to fund performance, they have low institutional ownership, their portfolios have higher liquidity risk and they face highly correlated liquidity shocks.
From the perspective of the stocks, issuers that are held by more-fragile funds and issuers with, “higher illiquidity ranks within funds’ portfolios experience greater returns to liquidity provision during market stress,” the paper noted.
The findings have potential implications for market players and regulators alike.
“Understanding how liquidity management works in practice is critical for policymakers, investors and market participants. It helps explain why certain stocks and sectors are more affected during crises and these findings can inform strategies to lessen the impact of liquidity shocks,” Rzeźnik suggested.