CAMBRIDGE, Mass. - The growth of mutual funds has shifted more risk to the household sector, according to Henry Kaufman, president, Henry Kaufman & Co., New York.
Once households saved in banks and insurance companies, Mr. Kaufman told the Behavioral Economics Forum at Harvard University recently. Now more and more, they save in mutual funds.
Banks and insurance companies take the risks of investment and insulate the households. Mutual funds pass the risks on to the shareholders, he said.
"When the financial markets get into trouble, the central bank will bail out banks and there is a system for supporting insurance companies," Mr. Kaufman said. "There is no system for bailing out mutual funds.
"There are 100 million shareholders of mutual funds today. The industry says the investors are long-term investors and will not abandon the industry when the market goes down. That has not been proven.
"It's a heterogeneous group. In the event of a market selloff, will the investors be passive? Perhaps the young investors will be, but can the middle-age investors be passive? The verdict on that is out."
Mr. Kaufman said mutual funds are one factor contributing to market volatility, and they will continue to contribute to volatility in the future.
"In the past 20 years we have seen massive securitization of financial assets," he said. "There has been rapid growth of marketable credit instruments which can move into and out of portfolios at great speed.
"More and more savings institutions are required to mark to market, and this is a way of shortening investment horizons. If you mark to market you have already taken the profit or loss. You are going to become more short-term oriented.
"There is an illusion that once you have marked to market, you have marked the portfolio to a price at which it can be liquidated. That may be so at times. But how much can you liquidate, especially in adverse times, in volatile market movements?"
Mr. Kaufman said there is an illusion of liquidity within the mutual fund industry. Technologically it's easy for a mutual fund to redeem a shareholder's shares, he said. "But unless the mutual fund has substantial liquidity, it has to sell stocks or bonds. Can the market function under those circumstances?"
The greater risk taken by the household sector also raises questions about the behavior of households should the value of their assets go down, he said. "Will household sector consumption decline?" Mr. Kaufman noted the household consumption sector has been one of the most stable factors in the economy.
Avi Nachmany, research director, Strategic Insights, New York, said the mutual fund industry has enough evidence to predict what its investors will do. In each bear market since the 1960s, investors redeemed less during the bear market, not more, he said. Even in Japan, redemptions declined in the bear market, he added.
"This is part of the psychology of investors. When people do not know what to do they do less of it," he said."
There are non-recurrent redemption spikes, Mr. Nachmany said. "These spikes last a week or two and then die out. You cannot extrapolate from them. In October 1987 there were 2% or 3% redemptions in equity funds, but they died out in November."
There have been structural changes within the mutual fund industry, Mr. Nachmany said. Now, more than 50% of the assets in equity accounts are in tax-exempt retirement accounts, and these are more stable assets. "These changes have made the business more sticky," he said.
In addition, he noted, market timing funds have almost disappeared.
Mr. Nachmany said the public thinks there are no long-term risks in stocks, only short-term risks.
Geoffrey Bobroff, president, Bobroff Consulting, East Greenwich, R.I., said he was not so sanguine about the statistics. In the 1980s, when people got near even on their losses from the 1970s, they got out of the stock market.
"Today mutual funds are an essential part of the financial fabric of America," he said. "We have the press, which is in the face of the consumer with issues every day. These days you get daily report cards. We are being rattled by short-term performance. There is a lot of concern today about job security. Will they (investors) let part of their nest egg be taken away today without doing something about it?"
Mr. Bobroff said investors almost have a "blind dependency on people like Morningstar (Inc.)," the Chicago mutual fund rating company. But Morningstar's rankings are all based on history.
"Morningstar was not around in 1987. We don't know what will happen if the stars get taken away quickly. Most of the money goes into funds with four or five star ratings," Mr. Bobroff said.
"We are likely to have a rapid correction when we have one, which will be healthy. But I have questions about investors' patience for a slow correction."
