If doomsday ever arrives on Wall Street, R. Steven Wunsch thinks mutual funds could be one of the worst places to be.
"Personally, I think (mutual funds) are all going to be death traps," said Mr. Wunsch, president and chief executive officer of AZX Inc., the New York-based operator of the Arizona Stock Exchange.
Although Mr. Wunsch acknowledges such a scenario is unlikely, he maintains that a flaw in the 1940 Investment Company Act could result in some investors getting wiped out in a free-falling equity market.
In his hypothetical example, investors who yank their accounts would get back their -- diminished -- assets, but those who remain invested could get wiped out because of a peculiarity in calculating the value of the departing investors' portfolios, Mr. Wunsch argued.
But mutual fund executives say Mr. Wunsch has some of his facts wrong, and, besides, various other safety features provide protection for investors.
Mr. Wunsch's statement that mutual fund managers don't track intraday flows involving block trades "is inherently false," said Brian Mattes, principal of The Vanguard Group Inc., Malvern, Pa.
Mr. Wunsch never has been shy to court controversy. In the 1980s, his efforts to win an exemption from the Securities and Exchange Commission definition of a stock exchange became an epic battle, pitting his David to the Goliath of the New York Stock Exchange. Eventually, the SEC sided with Mr. Wunsch.
THE PROBLEM IS NAV
His latest argument boils down to the 1940 act's requirement that investors who pull out of stock funds have their accounts valued at close-of-day prices, or net asset value.
Were the market to suffer huge drops -- perhaps on the order of 10 percentage points a day -- liquidity would dry up. That would prevent mutual funds from being able to unwind their positions, he said.
However, mutual funds still would be required to cash out investors at net asset values -- even if they were unable to sell the underlying stocks at closing prices, he said.
A key issue, Mr. Wunsch said, is that actively traded stock funds generally don't sell shares to pay off redemptions until the following day -- often because they don't receive redemption information on time.
In a steadily falling market, that means the fund would have to sell off more equities to redeem investors who cashed out at the previous day's net asset value.
Say the market loses 10 percentage points in value each day for four days (or over four years -- the initial time period is irrelevant). At that point, half of the fund's investors bolt for the exit.
While the fund is forced to cash out investors, it doesn't sell stocks until the next day, by which time the market has dropped another 10 percentage points.
The inability to liquidate stocks at prices used in calculating net asset value has a leveraging effect. The result: It takes twice as many stocks to cover redemptions because stock prices have been knocked down. Thus, only 40% of fund assets remain to cover the remaining 50% of the investors.
Even if the market bounces back, it's too late for remaining investors to regain their losses. In fact, they keep slipping further behind. After all, a 20% gain on 50 yields 60, while a 20% gain on 40 produces a value of only 48.
If the market's value halved -- dropping to 30% from 60% -- remaining investors would see their entire stakes wiped out.
"This is because the entire value of the remaining assets would be owed (and would already have been paid) to the redeeming investors," Mr. Wunsch wrote in a commentary before the market began to drop this summer.
In comparison, direct stock market investors suffer drastic market losses, but not total wipeout.
It wouldn't require everyone to run for the exit at once for that to happen. If stock mutual funds sought to liquidate a mere 1% of equity assets, that would produce a $24 billion selloff. In comparison, $1.3 billion in mutual fund stock redemptions helped cause a 7.2% drop on Oct. 27, 1997.
A one-day selloff on the order of $24 billion "would cause a meltdown all by itself," he said.
While this scenario is unlikely, Mr. Wunsch said, other events once considered remote possibilities have happened recently, such as the collapse of Asian markets and Federal Reserve Chairman Alan Greenspan's fear that markets might "seize up" if Long-Term Capital Management were forced to liquidate assets.
If mutual funds are unable to liquidate assets, it could create "a potential structural flood of unimaginable proportions," he said.
Using a fixed time for valuing fund assets, he wrote in the commentary, turns mutual funds into a "stock market derivative -- and one of the most dangerous kind -- as they are legally bound to promise a trade price without, in most cases, an acceptable means of executing at that price.
"This is eerily similar to the portfolio insurance promise to have a pension fund in the market if it (the market) was up, but out if it was down -- without having the means to execute that result."
That use of closing prices to value mutual funds, Mr. Wunsch maintains, "is potentially far more destabilizing than portfolio insurance ever was, and for the same reason: The practice can require executions that are far larger than the market can process in the required time frame."
Mr. Wunsch, of course, also has an ax to grind. He argues a market crash essentially is a failure to discover correct market prices. In a crunch, what is needed is a central mechanism by which buyers and sellers can find a correct equilibrium at a point in time, such as the single price call auction operated by Mr. Wunsch's own AZX or by other providers, such as Optimark.
But government policies are biased in favor of a continuously operating market and greater transparency. The effect is to fragment trades, making it harder to stabilize markets, he said.
A study by trading firm Investment Technology Group, New York, shows the "average trade size has barely budged" from 1993 to 1997, while average stock market capitalization has about doubled and the dollar volume of trading has gone up even more, Mr. Wunsch wrote in a subsequent article.
Nor has the average dollar size of trades of the biggest-cap stocks changed; in reality, the size of the smallest-cap stocks has plunged by 60%, he wrote.
The "circuit-breakers" introduced after the October 1987 market crash would not help, Mr. Wunsch said. If anything, they might exacerbate the situation, as traders rush to complete trades before markets are halted. A call market that had about 20% of market volume all the time would provide "a natural circuit-breaker," he said.
In his view, SEC officials should release mutual funds from calculating net asset values at a single time, and instead value accounts at the time orders are executed.
MUTUAL FUNDS RESPOND
But mutual fund experts think Mr. Wunsch's arguments are off the mark.
Some dispute that actively managed funds wait until the following day to liquidate shares in response to major reallocations by clients.
"Our technology gives us the capability to monitor what's going on minute by minute during the day," thus allowing quick reactions, said James Griffin, spokesman, Fidelity Investments, Boston.
"To presume that the portfolio manager does not get information during the course of the day is wrong," said Vanguard's Mr. Mattes. The problem occurs when orders for large block trades come in from institutional clients, such as 401(k) plans, he said. In that case, "the manager certainly knows about it," he added.
In addition, the portfolio manager has the right to refuse any trade detrimental to the health of the overall fund, he said. Such rights are written into prospectuses, and known by clients.
Even then, mutual funds have backups in case of illiquid markets. For one thing, they have the right to pay out distributions "in kind" -- that is, in the underlying equities, he said.
Mutual fund complexes also typically have bank lines of credit backing up their funds. And a couple of houses, including Fidelity and Vanguard, have created intrafund lending capabilities. In Fidelity's case, borrowing from other Fidelity funds is in addition to bank lines of credit. Vanguard has replaced bank credit lines with intrafund borrowing.
SOME USE DERIVATIVES
In addition, some houses use derivatives to provide liquidity. J. Parsons, managing director of Barclays Global Investors, San Francisco, said liquidating futures can cover the first 10% to 15% of assets.
What's more, some argue, funds should pay out the fair market value of an investor's account when net asset value does not reflect reality.
"If you believe that the closing price at the end of the day is not the fair price at which (stocks) can be traded, you have the obligation" to pay out the fair-market value, Mr. Parsons said.
Fair-value pricing can be particularly helpful dealing with volatile international markets, given the time difference between their closing and when NAV is calculated.
Still, Mr. Wunsch believes these safeguards have limited value in a free-falling market, merely putting off the inevitable liquidation of stocks.