It may be easy to get in, but like the appropriately named Hotel California hard to leave.
“Relax, ” said the night man, “We are programmed to receive
You can check out any time you like, but you can never leave”
When bulls try to escape pursued by bears, they may find themselves like the guests of Hotel California.
Could we be heading for a mutual fund crisis?
In determining whether or not investor panic or a ‘dash for cash’ could cause severe difficulties for the mutual fund industry and have a consequent impact on wider financial markets, it is important to consider the types of funds that have potentially illiquid or hard to value characteristics., the type of investor and the ways in which mutual funds are owned (direct or indirect)
Understanding the basic principles
Most mutual fund failures are down to the liquidity of the underlying investments or inability to find a reliable and up to date market prices at which to value some or all investments. In trying to determine whether funds may be vulnerable to some future market disruption, turbulence or unanticipated changes it is worth just revisiting two key principles on which the whole concept of mutual funds or collective investment funds as they are known in some countries is based.
1.Liquidity.
The law and regulation of mutual funds include the absolute right of investors to cash in at the current market value and so requires the manager to be able to sell investments to raise the money to pay them out. This means that the investments should be liquid – that is that they can be sold in in reasonable quantities any day at or close to the market price… Typically, funds might divide the investments they hold into four categories – highly liquid, moderately liquid, less liquid, and illiquid. This is a measure of how quickly sales can be made to meet redemption requests and a guide to the vulnerability of the fund to large volumes of redemption requests. Of course, the cash from inflows may be used to pay outflows. But there is insufficient cash coming in or already held or that can be raised to pay out all the investors who wish to redeem or if the market prices are so uncertain and volatile as to make sales difficult to make at a reasonable price that day, there are various permitted actions that can be taken either to defer redemption or to limit the amount to be redeemed at any one time, known as gating. or transferring unsalable assets to a special fund, side pocketing. But it will have to be established that doing so protects the rights of ongoing investors and cannot be maintained indefinitely. Some funds whose purpose is to invest in relatively illiquid asset classes write into their constitution restrictions on redeeming, say, more than 5% of the fund at any one time, thus providing breathing space.
2. Valuation.
In order to treat all investors, whether incoming, outgoing or ongoing, fairly the underlying investments must be capable of being valued at a current market price. So as to ensure that new buyers of shares pay the right price: sellers receive the right price: and continuing investors are not diluted. If reliable valuations cannot be established, it may be necessary to rely on some of the options available to delay dealing in find shares until the abnormal market conditions that led to the need to suspend return to what is considered normal. If for any reason it seems unlikely that particular assets or a majority may not be able to be accurately valued for the indefinite future, then liquidation of the fund may the only solution.
Some examples of failure
Fortunately, it is rare for open ended funds in developed markets to have to suspend dealings altogether for reasons of extreme illiquidity.
Among notable examples, which had a large public base of retail investors have been the following: the fact that these became notorious was because they had drawn in millions of small retail investors based on past good performance which had either depended on illiquid investments or unexpected changes in market values or extreme volatility that made accurate valuation for redemption impossible.
The Unit Trust of India which had invested in illiquid or unlisted companies had to suspend redemption trapping millions of small investors. It separated liquid from the illiquid investments that were transferred to a special fund financed by the government.
The US Reserve Primary Fund in 2008 that held short term paper of collapsed investment bank Lehmann Bros and so called ‘broke the buck’ thus becoming unable to its obligation to redeem at $1.
French domiciled H2O funds that allocated substantial sums into opaque, illiquid private bonds and securities linked to a private investment vehicle.
Arch Cru in the UK that manipulated its price using offshore subsidiaries which proved to be unsaleable when redemptions rose.
UK open ended daily dealing property funds after the Brexit vote suffered from a ‘dash for cash’ and since the investments in property could not be quickly realised were forced to suspend for several months. This exposed the inherent flaw in funds that invested in illiquid assets that offered instant liquidity to investors.
Woodford Equity Income Fund shifted focus from large liquid companies to small biotech companies and when redemptions had drained the liquidity from sales of saleable investments it had to suspend and later close.
In determining whether or not investor panic or a ‘dash for cash’ could cause severe difficulties for the mutual fund industry and have a consequent impact on wider financial markets, it is important to consider the types of funds that have potentially illiquid or hard to value characteristics., the type of investor and the ways in which mutual funds are owned (direct or indirect)
Rapid continuing growth draws in more and more investors.
First the total value of mutual funds worldwide has expanded rapidly since 2008 from USD 27 trillion to USD 84 trillion at end 2025. It is worth noting that this includes Exchange Traded Funds. But what is particularly notable is that the number of funds has grown too but even faster in some regions, particularly in Asia., where the number of funds grew from 17,000 to 45,000 in the same period. While the US remains by far the greatest market with an estimated 130 million individual investors, whose behaviour may have a profound influence in the event of financial market uncertainty, it is notable that China where the number of investors grew from 70 million to 270 million from 2008 to 2025 and India where individual investors grew in number from 46 million to 280 million in the same period. (nb different ways of classifying investor accounts mean that the figures give a general impression rather than precise detail)
The type of investor
Many of the enormous number of investors that own mutual funds worldwide have only become relatively recent investors. In India for instance the total value of mutual fund assets grew from USD 51 billion to USD 156 billion in the five years to May 2026 and the number of investors grew from 23 million to 54 million; in China the number of investors reached an estimated 750 million in 2026. Many of these will not have experienced a major downturn and may well become very nervous and sell. In the US the number of investors grew from 100 million to 128 million in the same period. But many US investors as well as those in Europe and the UK wilt have experience downturns and learnt that they should hold on. In addition, mutual funds that are held in wrappers like pension funds and insurance vehicles, are not influenced by individual investors and therefore tend to stick. unless there is an attractive alternative. Even so those direct investors who are relatively new and were drawn in by the bull market may well get anxious and sell.
The role of ETFs
Much of the growth in the market over the past two decades has been in Exchange Traded Funds (‘ETFs’). They may not have the pressure on the need for liquidity to meet redemptions that conventional mutual funds have because their structure where the authorised participants who create the portfolios can absorb buy backs and the market makers provide a secondary market. This will hold true for all mainstream ETFs There is a churn in ETF numbers resulting from managers chasing trends with new offerings and trying to create new flows of sales (1000 in 2026 so far) and closing down zombies (220 in 2026 so far) which have passed their sell by date results in sales of the underlying assets in the market. Since such ETFs are usually small in size or in small specialist sectors this is unlikely to have a systemic impact. Nonetheless if volumes are such that neither can nor be prepared to exercise their function an ETF will have to sell in the market.
However, the rapidly growing sub sector of ETFs the so called active ETFs as opposed to the original index following version may present risks of failure, since they depend on decisions by the fund manager like active mutual funds despite the fact that lower fees, insulation from buying and selling by other investors in the fund and lower trading costs because of in-kind creations and redemptions have helped then outperform their more classical counterparts. There is no evidence that they will continue to outperform in the longer run. They may therefore face the same problems as actively managed conventional funds and experience withdrawals in a market panic.
More specialist funds
The most vulnerable types of fund are those that invest in private credit, real estate, and alternative asset classes that are inherently illiquid. The “retailisation” of alternative investments—bringing private credit, real estate, and private equity to everyday investors via user-friendly regulatory wrappers—will face a severe test if investors get nervous. While the marketing story that invites ordinary people to join the rich and institutional investors may be attractive to retail investors, it is by no means proven that alternative investments will beat publicly listed ones particularly when fees are taken into account. While most products are aimed at institutional wrappers like pension and insurance funds for instance, ELTIFs in the EU, LTAFs in the UK and interval funds in the US are standalone retail products and investor or adviser can pick actively, subject to rules on eligible assets, concentration, mandatory repurchases and disclosure. Attempts to dress up illiquidity as ‘semi liquid’ using partial gating or quarterly limits may be ignored by investors in search of better returns but will cause panic among investors more accustomed to fully liquid daily priced funds where they can get their money out quickly. There are already signs that this is causing problems, particularly for funds focusing on real estate, private fixed income and bonds as interest rates rise, notably the sustainability of the enormous amounts of debt being pumped out by the AI boom.
Concentration risk
This crosses all types of fund and product and is where perhaps the greatest risk lies. It is particular to index funds, whether ETFs or not. It may be geographical, sector or single asset related. How many retail investors know that when they buy an MSCI ACWI (all countries) indexed product they are actually investing 60% in the US and that the top ten stocks in the S&P 500 Index account for 40% of the value of the index? And, no surprise, those are all tech titans. Or that when you invest in those rapidly growing emerging markets that the Korea and Taiwan markets account for 50% of it with the 50% of the Korean market capitalisation accounted for by just two semiconductor giants and 40% of the Taiwanese index accounted for by just one chip company. So, when you buy the MSCI Emerging Markets index you are investing one third of your money in just three companies. That’s all fine so long as he estimates of the golden future of AI prove to be justified. So, you think you’re diversified? So, a 60/40 MSCI ACWI/MSCI Emerging Markets portfolio sounds wise. Actually, given the concentration effect, you are betting on the tech/AI boom continuing.
Circularity
The 160bn windfall from investments in other AI companies, is flattering earnings and raising concerns that paper gains are overstating the strength of the AI boom.
Big Tech groups’ investments in OpenAI and Anthropic have increasingly shown up in their financial reporting in recent quarters, as accounting rules dictate that changes in the value of equity investments at the end of each quarter appear as part of the company’s profit or loss. This casts some doubt about the valuations that many of them have reached.
The example of 1929 is instructive. In 1929, investment trusts formed a dangerous “circularity pyramid” through heavy cross-shareholdings, shared directors, and leverage that turned falling prices into a massive market collapse. Investment trusts bought shares in each other and in the companies they managed, creating a closed loop of artificial demand. Managers used heavy debt and bank loans to buy more assets, driving stock prices up.
Indexation risk
While it may seem counter intuitive to include indexation in an analysis of risks the concentration of indices in a particular sector -technology/AI- has the effect of creating momentum in the index derived from just a few components. Therefore, the big increases in value of those components drives the whole index and gives an illusion of economic and financial success across a whole economy. While AI may be transformative in the long run its immediate benefit may be being overestimated. Indexed ETFs are becoming drivers of momentum as investors continue to buy into the rising trend and the ETF in turn is compelled to buy the stocks that created the momentum.
Triggers that may cause investor panic.
“Prediction is very difficult, especially if it’s about the future.” _Nils Bohr, physicist Nobel prizewinner for foundational theory of quantum physics.
Of course, lots of things you don’t need to be reminded about. High and rising levels of government debt and vast bond issues to fund data centres are putting pressure in interest rates and raising concerns about the ability of governments to raise the necessary funds: the uncertain outcomes of wars in the middle East and Ukraine; climate change and increasing number of natural disasters. These are events which, if they take an unexpected turn, could be the triggers for a sell off. But the development that might have the most shocking impact on financial markets and hence on mutual fund flows might be the realisation that the AI boom has overreached itself in driving high valuations which have so far rewarded investors. As I have shown , concentration in a sector with relatively few highly valued components has driven momentum as investors chase performance. But the reverse is also true. If there is a realisation that the sector concentrated on a few stocks is overvalued, the collapse in value will send shock waves throughout the system and high quality bonds with yields above 5% may offer an attratctive alternative.
All it is possible to say is that the preconditions are in place for a pretty sharp setback. Inexperienced investors, ever more complex and potentially illiquid funds, difficulties in valuation of assets and concentration in one overpriced sector. This will have a ripple effect across the whole sector which will cause valuation difficulties and a rising tide of redemptions or sales. I hope I am wrong.
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