Disclosure is a fundamental pillar of our market-based financial system. When information is accurate and complete, asset prices can reflect both expected return and risk. Yet, having information is one thing; using it appropriately is something else entirely. To evaluate the relative merit of a large number of potential investments, most people (including us) rely on specialists to do the monitoring: Independent auditors vouch for the accuracy of financial statements. Credit rating agencies tell us about the riskiness of bonds. Various brokers and specialized firms rate equities. And, for mutual funds, there are several monitors, of which Morningstar is the most prominent.
But, when the specialists fail to do their jobs, disaster can strike. Examples abound: auditors failed in the case of Enron; equity analysts overvalued technology firms during the dotcom boom; and rating agencies’ inflated assessments of structured debt contributed substantially to the financial crisis of a decade ago (see here). So, there is cause for concern anytime we see evidence that key monitors are falling short.
This brings us to the recent work of Chen, Cohen and Gurun (CCG) on Morningstar’s classification of bond mutual funds. They argue that mutual fund managers are providing inaccurate reports, and that Morningstar is taking them at their word when better information from standard disclosures is readily available. In this post, we describe CCG’s forensic analysis, but we don’t need to postpone our conclusion: if we can’t trust the monitors, then markets will not function properly….
In the aftermath of Britain’s July 2016 vote to exit the European Union, six U.K. open-end property funds with nearly £15 billion in assets suspended redemptions. These funds had routinely engaged in an extreme version of liquidity transformation: offering investors the ability to convert their shares into cash daily on demand, while holding highly illiquid commercial properties. Fortunately, the overall sector was small, and its post-referendum disruption neither spilled over broadly to funds holding other assets, nor prompted a wave of fire sales that might have undermined the balance sheets of leveraged intermediaries. Nevertheless, the episode was of sufficient concern that the U.K. Financial Conduct Authority (FCA) is now reviewing its “regulatory approach to open-ended funds that invest in illiquid assets” (see here).
The FCA is not alone in its concerns. Other regulators have been looking closely at risks associated with the liquidity transformation performed by open-end funds. And, interest in the official sector has been accompanied by a wave of academic research on liquidity management in open-end funds that generally buttresses the regulators’ concerns. In this piece, we briefly highlight the work of the regulators, summarize the research, and finally reprise our proposal to convert open-end funds into exchange-traded funds (ETFs).
