Recent market ructions and high profile fund failures appear to be focusing regulator attention on liquidity.
At the recent European Fund and Asset Management Association’s annual conference; Steven Maijoor, chairman of the European Securities and Markets Authority, called on fund managers to ensure liquidity risks were being properly managed and their funds could withstand future shocks.
He particularly highlighted concerns on corporate debt and real estate funds.
Recent experience suggests Maijoor may be right to be concerned.
The UK fund industry saw the implosion of Neil Woodford’s investment business in 2019 as the result of a liquidity crunch, while the pandemic has seen around 80 European funds, holding $40bn (€30bn) of assets, close to redemptions.
According to Fitch, around half of these closures (51%) were property funds, but there were suspensions across multiple asset classes.
The ratings agency says: “Fixed income funds were the second most prevalent in our study (35%). This is consistent with the recent ESMA study, which focused on property and corporate bond funds in the March 2020 stress period.”
Mixed funds accounted for 8% and 4% were equity funds.
It adds: “Since March 2020 a number of funds have re-opened. In other cases funds have liquidated rather than re-open. The funds that remain closed tend to be those invested in less liquid asset classes and/or where valuation uncertainty remains.”
Fund claustrophobia
Fitch believes that liquidity risk will be a major focus for the regulatory community from here.
“One of ESMA’s priorities for 2021 is fund liquidity risk, and regulatory convergence as it relates to extraordinary liquidity management tools such as swing pricing.”
The regulator is highlighting a problem that most have been aware of for some time. Property investors will be grimly aware that they are at permanent risk of being trapped in their funds.
Bill Dinning, chief investment officer at Waverton Investment Management, says: “Since 2008, many UK open-end commercial property funds have had to ‘gate’ on three occasions – 2008 in the Global Financial Crisis, 2016 post the Brexit vote and now in 2020.”
However, while property is the obvious example, liquidity problems are not confined to property funds.
Peter Spiller, manager of the Capital Gearing Trust, says: “There is nothing new about liquidity mismatches. Banking has always relied on the fact that not everyone will need their money at once and this also applies to the asset management industry.”
Liquidity problems can happen across multiple asset classes.
He adds: “In early March, for example, it was difficult to trade US treasuries, which are usually the most liquid asset in the world. Spreads began to widen. The Federal Reserve put it right very quickly, but it shows that there is no asset class that can guarantee a certain level of liquidity.”
As such, it is not enough to argue that funds should ensure a rigorous match between the liquidity offered to investors and the liquidity in the underlying assets.
Wrong time, wrong place
Liquidity is variable and usually not there when investors need it most.
That said, says Tatjana Greil Castro, a portfolio manager at Muzinich & Co., it is realistic to differentiate on settlement times.
“The bond market trades at T+2, which is shorter than the liquidity offered by Ucits funds. In that regard, the liquidity is there. The problem is volatility – you can raise cash but not at the price you expect.”
In the wrong market, all assets are vulnerable to this type of problem.
However, in assets such as property or loans, there is a question not only of the price – that investors may be forced to sell below the real value of the assets – but also of the settlement time.
It may take months or more to receive the cash on a commercial property transaction even after the price is agreed.
The solution, for many, is to hold significant cash reserves to meet short-term liquidity needs.
Castro says: “The problem here is that it is very expensive. In Europe, investors may be charged as much as 75bps for holding cash. That is a huge drag on performance.”
Spiller agrees, pointing to some property funds that are only 80-90% invested.
What are the potential solutions?
Fund managers need to do their own assessment of the liquidity risks in their funds, taking into account different scenarios.
Dinning says: “Our performance and risk team does rigorous internal modelling using trading volume data on securities owned in the portfolio to determine what proportion of a portfolio could be sold in three days under all market conditions and we set limits around those numbers.
“We assume that under normal market conditions we can be 20% of the volume traded in a security, in stressed market conditions we assume we can trade 10% of the volume and in very stressed conditions we model 4% of normal volume. For highly liquid funds such as our Global Equity Fund, 100% of the portfolio needs to be able to be liquidated in three days under all market conditions.
“All our fund managers also do liquidity checks before buying a security to understand the impact owning it will have on the overall liquidity of the portfolio.”
Castro says swing pricing is a reasonable solution, ensuring that existing investors do not pay for the liquidity needs of others: “The problem is that the investor doesn’t know the price they will receive, which makes it difficult to take a decision.
“With ETF pricing, investors know what they get. The other option is to put gates up, but that is a commercially difficult decision.”
For her, the best way is for fund managers to have strong relationships with the banks. A relationship of trust helps ensure they are the first in line when there is liquidity squeeze.
Closed-ended funds are also an option. These have a fixed pool of assets. They may move to a discount or premium to their net asset value on sentiment grounds, but the underlying assets are protected.
The problem is that smaller closed-ended funds may not be particularly liquid in themselves. Spiller believes wider use of Zero Discount Mechanisms or realisation shares can be an option.
He gives the example of BlackRock Frontiers Investment trust, which offers shareholders an opportunity to tender their shares at net asset value (NAV) at five year intervals: “This seems a sensible structure for property funds. It gives the fund manager plenty of time to sell if necessary.”
There is no easy solution to the problem of market mismatches in the market. Liquidity is variable.
However, it has long been clear that the open-ended structure is unsuitable for assets that are structurally illiquid, rather than cyclically illiquid and that may be where investment managers should draw the line.
