The Lessons from Toilet Paper Panic Buying
Risk Return Metrics
Toilet paper panic buying has not been isolated to Australia – it has also hit Japan, Hong Kong, Germany, the United States, and others. This panic buying is the result of the fear of missing out. More pertinently, it can be explained by John Nash’s game theory. Under game theory there are two players – you and everyone else. There are two strategies in this context – panic buy or act normally. Each strategy has an associated pay-off.
If everyone acts normally, we have an equilibrium: there will be toilet paper on the shop shelves, and people can relax and buy it as they need it. But if others panic buy, the optimal strategy for you is to do the same, otherwise you’ll be left without toilet paper. Everyone is facing the same strategies and pay-offs, so others will panic buy if you do. The result is another equilibrium – this one being where everyone panic buys. So either no one panic buys (a successful coordination) or everyone does (a coordination failure).
Let’s flip that around to panic selling and the investment markets in relation to pooled vehicles (funds, ETFs, etc) and separately with respect to debt and equities investment vehicles.
In debt, when you invest in an open ended fund you take on certain risks over and above the asset class. You now need to ask additional questions such as will the co-investors exit at an inappropriate time? Will you be left more exposed to lower quality or less liquid securities as some co-investors depart and assets are sold to fund redemptions? Will the bid/offer spread be sufficient to cover the costs incurred by co-investors leaving the fund (and didn't they blow out Monday U.S. time)? Will the manager use gate mechanisms to protect their interests or your interests? If there is leverage in the vehicle, will there be a capital call in order to stop fund assets being liquidated prematurely?
Open ended pooled debt funds are a much more difficult risk to analyse (over and above the underlying asset class) as you are forced to make decisions not only about what liquidity might be available for the investments held but also what actions others might take. If the fund has illiquid investments but regular liquidity options investors are at risk. Again perception is key, if the fund is seen as low risk then investors are more likely to stay and liquidity issues can remain suppressed. However, if a fund is perceived as risky its demise is almost guaranteed. Once redemptions begin en masse, remaining investors perceive they are at a high risk of being left stranded and the safest option is to redeem immediately.
Risk mitigation? A fund’s resilience in illiquid markets is related to their size (larger means more diverse investors, counterparties and assets).
In an equities open ended trust, of course a manager may be forced into selling off their highest quality companies at undervalued prices through sharp sell-offs to fund redemptions. Loyal investors during these periods may be left as investors in the remaining lower quality less liquid stocks in the fund. But in equities, unlike debt, unit trust investors face another risk – being subject to the taxation implications of the trading activities of other investors. Net redemption requests may require the manager to sell underlying portfolio holdings which, in turn, may crystallise a capital gain. This leads to the distribution of a CGT liability to remaining investors. Furthermore, the level of the CGT liability may be a function of gains accumulated well before an investor entered the unit trust (creating ‘inter-generational’ issues). During the GFC some investors both (substantial) negative returns plus a tax bill on the fund’s crystallised gains. Good times!!!
In open ended vehicles in times like this, there’s the impact of the market PLUS the potential risk of a coordination failure from fellow investors. Choose your optimal strategy carefully.
'In times like this' . . . in times like future - climate change related fight for resources? . . . . ouch . . . . the edifice ;).