Measuring the systemic risk contribution of international mutual funds

Measuring the systemic risk contribution of international mutual funds

During the global financial crisis of 2007–2009, the importance of the scale and correlation of entities in interconnected financial systems, especially on what have become known as “too big to fail” institutions in the global financial system, was clearly evident and spotlighted. Several proposals have been brought on by regulators in the United States (US), covering insurers, asset management funds, private equity firms, hedge funds, and mutual funds (The Economist 2012). Against this backdrop, it is useful to examine systemic risk of international investment. In this article, we focus on the mutual fund sector, for which net assets under management have totalled almost $30 trillion over the last decade, accounting for more than 50% of global market capitalization (Investment Company Institute 2013).

International mutual funds can be subject to liquidity and financial market runs due to redemptions. Our research objective is to provide new evidence on the association between international investment and the propagation of systemic risk through capital flows in global financial markets. The study contributes to a growing literature on global financial interdependency and granularity in macroeconomics (see Gabaix [2011]). Jinjarak and Zheng (2014) provide related evidence on what the patterns of global risk would have been if regulations had been in place to cap the size of funds at a ceiling that would have eliminated the size of the top 20% (or 10%, or 5%, or 1%) of the funds, assuming that this would not have impacted the correlation patterns observed in the remaining 80% (or 90%, 95%, or 99%), as well as the propagation of global investment risk across markets. They find, for example, that idiosyncratic shocks to the largest 10% of funds investing in the US explain about 40% of the risk fluctuations in other non-US markets. To provide new evidence of systemic risk contribution in international capital flows, we examine the systemic risk of 10,570 mutual funds investing internationally from 2000 to 2011. Based on the CoVaR measure (Adrian and Brunnermeier, forthcoming), the main findings suggest that (i) systemic risk contribution increases with fund size, and (ii) systemic risk contribution is negatively associated with investment inflows and investment returns for the global financial crisis of 2007–2009, but not market tranquillity.

The estimated systemic risk contribution can be useful in studying many aspects of international capital flows. Tracking the performance consequences of systemic risk contribution, we also find that investment funds with higher systemic risk contributions have higher investment flows and better returns in the tranquil (non-crisis) period, but lower investment flows and worse returns in the panic (crisis) period. The impact of systemic risk contribution on investment flows and returns also appears to be regime dependent. When evaluating the determinants of systemic risk contribution, we find that larger funds are associated with higher systemic risk contribution and that the fund size effect is particularly important during the panic period. Moreover, we find a nonlinear relation between the prospective performance of investment funds and their systemic risk contribution. Funds with more negative prospective flows (that is, prospective outflows) are associated with lower systemic risk contribution. While the outflows reduce the size of funds and therefore their systemic importance, the expectation of significant outflows may be associated with fund managers becoming cautious with their investments, i.e., holding more liquid assets that can be quickly sold—this reduces the fund-specific risk and therefore systemic risk contribution. The nonlinear relationship may imply that higher prospective flows result in lower systemic risk contributions if the prospective flows are large enough. This possibility may be driven by fund managers’ intentions to maintain stable flow streams that keep the flow volatility low and improve fund performance (Rakowski 2010).

There are some limitations of our systemic risk measure of international investment and their relevance to capital flows. First, this measure may not fully differentiate whether systemic risk contribution is driven by idiosyncratic risk or common factors. Therefore, it is difficult to impose regulation calibrated on specific factors. Under efficient markets, comovements of financial institutions’ risk measures should convey information on both direct and indirect linkages across financial institutions (International Monetary Fund 2009). Second, here mutual funds are in distress when returns are low or negative. Given that mutual funds have no explicit leverage, it is a challenge to justify or motivate the “distress” of a mutual fund. Several possibilities include, for instance: severe and persistent redemptions may be a better sign of a distress for an open-ended fund; low absolute returns or under-performance against the benchmark; and aversion to being the worst performer among peers may matter more. Third, it remains to be seen whether the absolute size of a fund matters in practice. In terms of the impact on asset prices and systemic risk, a more meaningful factor may be the presence of a fund active in a specific market compared to the size/liquidity of the asset market (big fish in a small pond). An even more important aspect is correlation across mutual funds due to clustering of investor flows and fund managers’ purchases/sales of assets as well as common use of benchmarks. Even though individual funds or individual investors are small in size, when they move in the same direction their market impact will be large (see Miyajima and Shim [2014]). Also, redemption-driven sales and fund manager sales are positively correlated (Shek, Shim, and Shin 2015). This implies that the macroprudential approach is more important than the microprudential approach for the risks of individual funds. Fourth, our findings are in line with an IMF study (albeit with smaller number of funds). A study by the International Monetary Fund (2015) uses Adrian and Brunnermeier’s (forthcoming) CoVaR and runs quantile regressions on about 1,500 funds investing in different asset classes. The findings show that funds’ contributions to systemic risk depend more on their investment focus (that is, asset class) than on their size; the average contribution to systemic risk does not increase with a fund’s parent company size.

Overall, our new evidence on systemic risk contribution in the international mutual fund sector from 2000–2011 highlights that the systemic risk contribution of international mutual funds significantly increased with fund size during the financial crisis of 2007–2009. In the tranquil (non-crisis) period, systemically risky funds (mutual funds with systemic risk contribution in the top quintile) have greater investment inflows and higher returns. In the panic (crisis) period, systemically risky funds have more investment outflows and lower returns. In both the tranquil and panic periods of the global financial system, systemically risky funds tend to become less systemically risky over time. When the market is tranquil and systemic risk is relatively low, systemically risky funds become bigger due to larger investment inflows and returns. When the market is in financial turbulence and systemic risk is relatively high, systemically risky funds face larger investment outflows and negative returns, which thereby reduce their systemic risk contribution.

Adrian, T., and M. K. Brunnermeier. Forthcoming. CoVaR. American Economic Review.
Gabaix, X. 2011. The Granular Origins of Aggregate Fluctuations. Econometrica 79: 733–772.
International Monetary Fund. 2009. Responding to the Financial Crisis and Measuring Systemic Risks. Global Financial Stability Report. April. Washington, DC: IMF.
International Monetary Fund. 2015. Navigating Monetary Policy Challenges and Managing Risks. Global Financial Stability Report. April. Washington, DC: IMF.
Investment Company Institute. 2012. 2012 Investment Company Fact Book. 52nd Edition. Washington, DC.
Jinjarak, Y., and H. Zheng. 2014. Granular Institutional Investors and Global Market Interdependence. Journal of International Money and Finance 46: 61–81.
Miyajima, K., and I. Shim. 2014. Asset Managers in Emerging Market Economies. BIS Quarterly Review. September.
Rakowski, D. 2010. Fund Flow Volatility and Performance. Journal of Financial and Quantitative Analysis 45(01): 223–237.
Shek, J., I. Shim, and H. S. Shin. 2015. Investor Redemptions and Fund Manager Sales of Emerging Market Bonds: How are They Related? BIS Working Paper No. 509. August.
The Economist. 2012. Scale in Financial Services, in the Fed’s Sights. New York, print edition. 14 April.

Photo: By [CC BY 2.0], via Wikimedia Commons

Joshua Aizenman

About the Author

Joshua Aizenman is Robert R. and Katheryn A. Dockson Chair in Economics and International Relations and professor of international relations and economics, Department of Economics, University of Southern California.
Yothin Jinjarak

About the Author

Yothin Jinjarak is an associate professor, School of Economics and Finance, Victoria University of Wellington.
Huanhuan Zheng

About the Author

Huanhuan Zheng is an assistant professor, Department of Economics and Institute of Global Economics and Finance, The Chinese University of Hong Kong.
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