An ongoing focus on potential liquidity mismatches may help avert the risk of liquidity squeezes for investment funds. PAUL STILLABOWER, Head of Product and Profitability, Core Services at RBC Investor & Treasury Services (RBC I&TS) notes in this RBC I&TS article, that there is a regulatory expectation that liquidity management is monitored on an ongoing basis. ‘Should a fund invoke a suspension of dealing, regulatory authorities and investors are likely to question why this scenario was not foreseen or adequately planned for.’
Over the last five years, there have been several high profile liquidity squeezes for investment funds. In 2015, Third Avenue, a US mutual fund trading high yield bonds stopped client redemptions in the biggest crisis to face the money market funds industry since the Reserve Primary Fund “broke the buck” in 2008. Less than a year later, a number of UK open-ended property funds were forced to gate GBP 18 billion in client cash following the Brexit vote.1
In 2019, the UK Equity Income Fund managed by Neil Woodford suspended client withdrawals when it too suffered a liquidity mismatch.
• With a relatively low number of funds experiencing suspensions, the industry has weathered recent liquidity challenges
• Open-ended fund liquidity remains an area of interest for regulators
• Firms should continue to consider the liquidity terms they offer and ensure that the terms correspond with the asset composition of their portfolios
• Regulators have adopted a number of provisions designed to strengthen liquidity risk management, and more may follow.
The volatility spurred by COVID-19 and resulting asset price fluctuations in March also created liquidity challenges for several fund managers. At the same time, margin calls on over-the-counter (OTC) and uncleared derivatives increased exponentially. According to data from the Bank of England, initial margin required by UK central counterparty clearing houses (CCPs) peaked at 31 percent above the average in March 2020.2
Together with the large volumes of investor redemption requests, a number of fund houses struggled to manage cash balances in the early days of the COVID-19 crisis. Fitch reported that at least 76 European mutual funds–with assets totalling USD 40 billion–suspended trading in March, as did one exchange-traded fund (ETF).
While suspensions are unwelcome for those investors looking to redeem, the suspension mechanisms, such as those that focus on liquidity and material valuer uncertainty, are intended to protect the interests of all investors in a fund. Within the context of the European funds industry overall, which includes approximately 34,000 UCITS with assets in excess of EUR 10.5 trillion, fund managers are generally using effective liquidity monitoring and management practices.
Maintaining robust risk management approaches plays an important role in helping to prevent wider disruption during periods of volatility.
Paul Stillabower, Head of Product and Profitability, Core Services at RBC Investor & Treasury Services also notes that, “There is a regulatory expectation that liquidity management is monitored on an ongoing basis. Should a fund invoke a suspension of dealing, regulatory authorities and investors are likely to question why this scenario was not foreseen or adequately planned for.”
Regulatory scrutiny continues
Regulation of liquidity risk management practices at investment firms pre-dates COVID-19. Since 2018, US mutual funds which have more than USD 1 billion in assets have been required to classify portfolio holdings into four separate liquidity categories.4 Also in 2018, the European Securities and Markets Authority (ESMA) announced that UCITS (Undertakings for the Collective Investment in Transferable Securities) and AIF (alternative investment fund) managers must conduct portfolio stress tests and disclose any potential risks to regulators.5 It also added guidelines for depositaries noting they should check that managers have documented processes in place providing information about their liquidity stress testing programs.6
More recently, ESMA called for a common European Union (EU)-wide framework on liquidity risk management in its AIFMD (Alternative Investment Fund Managers Directive) review.7 The UK's Financial Conduct Authority (FCA) is also taking liquidity risk management seriously, having introduced a new disclosure regime specifically for open-ended firms trading illiquid securities.8 In August 2020, the FCA launched a consultation asking whether it would be prudent to increase the redemption notice period, which investors must provide to open-ended property fund managers, to a period of between 90 and 180 days.9 Real estate funds can be particularly challenging given the inherent liquidity mismatch between daily dealing and the typical timescale required to complete a real estate transaction.
Post-Woodford, regulators are paying closer attention to the liquidity profiles of asset managers and checking that they correspond with the liquidity terms promised to investors in prospectuses and offering memoranda. “Regulators are catching up on this and will, I am sure, revert with much more stringent criteria to ensure the liquidity terms described in marketing materials are accurate,” says Rikard Lundgren, an independent fund director in Luxembourg.10
While it is relatively benign for regulators to say that illiquid assets such as property should not be traded in daily dealing funds, safer assets including government bonds or listed equities are not always insulated from market downturns. “The liquidity mismatch issue is less clear cut for funds investing in assets that most of the time are easy to sell while at other times, especially in market downturns, become unsellable,” says Lundgren.
Would a new redemption structure further mitigate liquidity risk?
Surges in redemption requests can potentially destabilize markets as managers will often 'fire-sell' securities to meet redemption requests resulting in asset price volatility. Moreover, the early first movers may benefit at the expense of those still left in the fund, which are more likely to be retail investors. There are several mechanisms by which asset managers can insulate remaining investors from the dilutive effect of redemption, and also subscription activity. For example, they can implement swing pricing whereby transaction costs and differences between mid and bid offer prices are passed on to investors who are either subscribing or redeeming fund units. Firms may also choose to impose anti-dilution levies (ADL), although, similar to swing pricing, this mechanism is designed to counter the effects of net asset value (NAV) dilution arising when dealing in the underlying assets to reflect subscriptions and redemptions and is not strictly a liquidity measure.
Lundgren believes these options do not go far enough. “Swing pricing and ADLs only partly solve the advantage of the first-to-redeem investor, who is getting their money back from the sale of more liquid assets and thus disadvantaging the remaining investors,” he says.
Instead, asset managers may want to consider thinking more laterally about how they fulfill significant redemption requests. “A better way could be to have a multi-tranche redemption schedule, where all investors get equal access to the liquidity available in the asset markets and equally suffer the longer waiting periods for those assets that cannot be sold as quickly. New prospectus language reflecting this would be welcome,” says Lundgren.
The existing in-specie approach, which is comparable, allows in-specie redemptions for significant redemptions over a pre-set percentage of the fund, which allows investors to receive a proportionate share of all assets, both liquid and illiquid. The multi-tranche schedule approach, however, may be more efficient and practical to administer, and perhaps fairer as in-species typically cannot be enforced for redemptions less than a set percent as stated in the prospectus. Regulatory permissions would of course need to be confirmed across jurisdictions.
Regulators are carefully examining liquidity risk management for certain open-ended funds (e.g., real estate). Despite being delayed because of COVID-19, the UK FCA and Bank of England are conducting a review into the daily dealing practices of such funds. As the COVID-19 experience has shown, liquidity mismatches can result in trading suspensions. And while it is an infrequent event, nonetheless, every suspension represents a failure to deliver to investors the key distinguishing feature of an open-ended fund–the ability to have their investment redeemed on a date of their choosing, subject to the conditions of the fund's prospectus.
“The promises made in the prospectus to investors about access to their money needs to reflect this fair-weather-friend liquidity dynamic better,” says Lundgren.
Paul Stillabower is Head of Product and Profitability, Core Services at RBC Investor & Treasury Services.
1Reuters (July 5, 2016)Number of UK funds suspended since Brexit doubles.
2Bank of England (June 10, 2020) What role did margin play during the Covid-19 shock?
3Fitch Ratings (April 20, 2020) European Mutual fund gatings rise as Coronavirus spooks markets.
4Financial Times (September 8, 2017)New US liquidity rules strain mutual funds.
5ESMA (September 2, 2019)ESMA strengthens liquidity stress tests for investment funds.
7ESMA (August 18, 2020)Review of the Alternative Investment Fund Managers Directive.
8RBC I&TS (November 4, 2019) Changing the liquidity goal posts.
9FCA (August 3, 2020) CP20/15: Liquidity mismatch in authorised open ended property funds.
10Exclusive interview with Rikard Lundgren. For additional commentary from Lundgren on liquidity, visit SteenDier.com