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Can a “Run on the Bank” Occur with Mutual Funds?

A reader writes in, asking:

“What happens when an investor in a fund sells their shares? Who buys the shares? And what happens if more people want to sell than buy? Is it possible to have something like a ‘run on the bank’ in which the fund crashes because many investors pull their money out at the same time?”

What happens when you sell a fund depends on whether it’s:

  • an ETF (or closed end fund) or
  • a traditional (“open-end”) mutual fund.

When you sell an ETF or closed-end fund, the transaction is between you and a third-party buyer. And the price of the fund will be determined by what the buyer is willing to pay for it. (The share price of the fund, however, is typically very close to the value of the underlying investments because institutional investors perform arbitrage trading in order to capitalize on — and eliminate — any such discrepancies.)

When you place a sell order for an open-end fund (e.g., Vanguard’s ordinary mutual funds), the transaction is between you and the fund company. The fund simply pays you cash equal to the NAV of the share you sold.

Background: At the end of trading each day, the total value of the assets the fund holds is divided by the number of shares outstanding. The result is the Net Asset Value (NAV), which is the price at which buy and sell orders of the fund will be executed that day.

In other words, as a fund shareholder, the value of your fund shares will be determined primarily (or exclusively) by the value of the underlying assets held by the fund. And, for the most part, the value of the underlying investments won’t be strongly affected by the actions of other investors in the fund, because most funds own only a small percentage of the total market value of each of their holdings.

For example, Vanguard’s Total Stock Market Index Fund — an absolutely massive fund — owned $5.63 billion of Exxon stock as of the end of 2011, according to Morningstar. Given Exxon’s total market capitalization of $401 billion, that’s just 1.4% of the company. Obviously the actions of the other 98.6% of the stock’s shareholders will be the dominant factor in the stock’s performance. And the same sort of analysis applies for most holdings in mutual funds.

Conclusion: When you own a mutual fund, the bulk of the risk you take on is the result of factors outside of the fund itself, not the result of actions by other shareholders in the fund.

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Comments

  1. After a couple years of reading personal finance blogs I’ve never seen this addressed before, thanks! On a related note, could you comment on the risks associated with having all of your mutual funds in one company? For example, what are the risks of a company like Vanguard going bankrupt and investors losing their shirts?

  2. Hi Chad.

    As it happens, I’m currently in the process of working with a PR team member at Vanguard to get the answers to those (and related) questions for an upcoming article.

    For right now though, my understanding is that:
    1) Vanguard’s structure (where it’s owned by the funds it operates) makes it less likely that it would go out of business than other fund companies, and
    2) I don’t think it’s necessarily a problem for investors even if Vanguard does go bankrupt somehow. Each fund’s assets are held by a custodian separate from Vanguard, and I don’t think Vanguard’s creditors would have any claim to those assets whatsoever.

  3. I think the answer to the headline question has to be “yes.”

    It already happened with ETFs in the flash crash some time ago. For whatever reason, existing shareholders were trying to sell a lot of shares and there weren’t enough investors willing to buy those shares. So the prices kept dropping, to ridiculous levels. Fortunately it didn’t last long. Some trades were reversed but many were let stand. The affected shareholders suffered a run on the bank.

    It also happened with an open-end mutual fund — the Reserve Primary fund. Existing shareholders with a lot of shares cashed out at a price higher than the fund’s true NAV. Shortly after that the fund found out the assets it held weren’t worth what it thought they were worth. The remaining shareholders suffered a run on the bank.

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