November 2016

LIQUIDITY: Not a drop to drink

Prior to 2008, liquidity risk was on the radar of few investment managers. Many financial models even omitted the risk. However, the financial crisis demonstrated just how crucial liquidity can be for funds, investors and the wider financial system. With markets increasingly volatile and investors jittery, the risk of a liquidity crunch is high and rising. Could fund managers weather such a storm? Kit Klarenberg investigates.

In April this year, the International Capital Markets Association (ICMA) and the European Fund and Asset Management Association (Efama) jointly released a report urging EU member states to make as many market-based tools available as possible to support fund liquidity.

The report was issued in response to public concerns that funds may be inadequately equipped to meet redemption demands in difficult market conditions. It found that in several leading asset management jurisdictions, crucial liquidity tools – such as swing pricing, dilution levies, dual pricing and side pockets – were not available to fund managers.

Belgian managers were the worst served, with dealing suspension the sole tool available. German managers were not much better equipped, with only dealing suspension, dual pricing and non-cash redemption on offer. Funds in Italy, the Netherlands and Spain, while better kitted out, still lacked a full set. Conversely, while the complete range is accessible in France, Ireland, Luxembourg and the UK, the bodies found the tools were not widely exploited there.

Six months on, Patrik Karlsson, director of market practice and regulatory policy at the ICMA, believes there’s been scant tangible progress on the issue, with industry players at best taking “baby steps”.

“The European Securities and Markets Authority (Esma) responded positively to the report, but they haven’t officially endorsed it. On the other hand, national regulators have been more proactive in their responses,” he says.

“The German Federal Financial Supervisory Authority (FFSA) particularly welcomed our findings, and has indicated it intends to address the issue.”

The failure of asset managers to act on fund liquidity is troubling, even if it can be chalked down to sluggishness, rather than an absence of will. Just how vital liquidity tools can be was starkly underscored in the weeks following the June 23 referendum on the UK’s membership of the European Union; panicked investors rushed to redeem their investments in UK property funds, but due to a lack of liquidity, half of the total fund market was forced to temporarily shutter. Those that avoided gating did so due to sizeable cash buffers, and/or an adjustment of the fund’s unit price.

Many of the affected funds took months to resume trading and some remain suspended; M&G’s Property Portfolio only resumed trading on October 21, and Aviva Investors has suggested its Property Trust could remain closed until March 2017.

Those that resumed trading were typically able to only after selling underlying holdings, rather than via the use of liquidity tools. The UK Association of Real Estate Funds is to investigate the episode, and see how best to reform property fund structures to prevent it being repeated; property funds could well cease offering daily dealing as a result.

LIQUID, LIQUID EVERYWHERE
Concerns over the applicability of liquid vehicles to illiquid asset classes are nothing new, but troublingly, research suggests even more liquid asset classes could somehow be likewise ill-suited to them at present. An October study released by ratings agency Fitch indicated up to 90% of Ucits bond funds were at risk of liquidity mismatch – being unable to sell underlying holdings to 
fulfil withdrawal requests – due to a unstable combination of rapidly falling prices and redemption spikes.

Credit markets have suffered frequent, episodic bouts of volatility driven by event risk in the past three years; during these periods of heightened stress, redemptions have sharply risen, while bond prices have fallen. Even if a bond fund is able to sell its underlying holdings in short order, it may still have insufficient funds to meet withdrawal demands. The current low-to-no-yield fixed income environment only aggravates the issue.

“In their search for higher returns, managers are increasingly attracted to riskier, more illiquid securities, such as high yield and lower-rated corporate bonds. By definition, this increases a fund’s liquidity risk significantly,” says Manuel Arrive, senior director of Fitch’s fund and asset management group.

Arrive is encouraged that many fixed income fund managers have taken steps to address these complications, upping their cash holdings and introducing swing pricing, many for the first time. Still, he feels not enough managers are taking measures – and the managers that have aren’t doing quite enough. As long as liquidity mismatch risk looms large, he suggests funds should shift to weekly dealing rather than daily, and institute longer notice periods – and those funds that are yet to adopt swing pricing must rectify this promptly.

Others worry that funds are creating fresh systemic risks in their collective quest to expand their cash cushions. Asset managers aren’t only growing their ready money by selling off underlying assets – some are sizeably increasing their credit lines (the amount of money they can borrow from banks) to do so. While ensuring investors can dependably pull their capital in volatile, difficult market circumstances is a judicious impetus in principle, some are deeply troubled by the trend’s practical implications.

“After the property crunch in June, funds investing in every asset class started worrying about whether they would be similarly in the lurch if a bulk of their investors made for the exit in a hurry, and we’ve seen many firms grow their liquidity in this way since – some quietly, others quite publicly,” says an investment regulatory professional, who asked to remain anonymous.

“We have advised our clients not to go down that road for a number of reasons. It’s an artificial safety blanket – it might help out in the short-term, but long-term there’s no guarantee they’ll have made the money back in time to keep up with repayments, and depending on how much they withdraw, they could be hit with sizeable interest bills.”

The off-the-record consultant goes on to suggest that the use of credit lines could also create an extremely hazardous vicious cycle, in which investors are more trigger-happy when it comes to redemption, confident that the fund can rely on borrowing to weather the hit in a stressed market scenario, exacerbating or creating a redemption spike in the process. In short, if a fund’s investors move in the same direction simultaneously, it could be catastrophic for any fund relying purely on a credit line for liquidity.

“Credit lines have become a bit of a craze, and I hope it doesn’t spread much further, or we may not have a fund industry left in the event of a serious market downturn. I blame Vanguard for kickstarting it – in September, they increased their credit line to over $3 billion, and lots of funds in the small to mid-size portion of the market decided to follow their example,” the consultant adds.

In short, the consultant believes there needs to be greater awareness of what this amounts to – leverage. It’s certainly unclear whether investors would be entirely thrilled that their risk profile has effectively been raised without their express consent.

A spokesperson for Vanguard says that while the firm has had effective access to a line of credit since 2009, it is yet to utilise it, and has typically enhanced liquidity through the sale of portfolio holdings. It is a resource only to be used as a last resort in emergencies, they add.

MONETARILY INCONTINENT
While asset managers are evidently keen to prove to uneasy investors and regulators that they have the reserves to weather an outflow deluge, for ICMA, the growing use of credit lines is a palpable demonstration that asset managers remain far too dependent on cash alone to see them through potential liquidity crunches. This continuing negligence implies catastrophic consequences in the event of a crisis – although, some asset managers question the true scale of liquidity risk in the market. BlackRock is among them.

In October, the industry giant published a report that suggests liquidity fears are overblown, and based on a flawed reading of markets.

For one, the report says, asset owners often have unrelated objectives and constraints that drive their behaviour in disparate ways, suggesting market participants may not respond to market conditions monolithically. Moreover, turnover data employed by Fitch et al has omitted critical elements of contemporary market structures, including ETF trading volumes, which have increased significantly as asset turnover overall has declined.

Omitting ETFs from market analysis is a particularly careless oversight, as ETFs are traded without their underlying securities being bought and sold.

Finally, the report concludes regulators in key jurisdictions have taken decisive action to enhance the range of liquidity management tools available to investors. However, the question of whether fund managers are actually utilising this assortment of instruments isn’t explored – and ICMA firmly believes managers aren’t at present.

While appraisals of liquidity risk in the market evidently vary significantly, it’s surely better to be safe than sorry – especially when a firm’s reputation, assets and perhaps very existence could be threatened by a liquidity crunch, and most developed nations have a comprehensive toolkit on offer.

Managers have adjusted to longer investment horizons in recent years, but have sometimes struggled to communicate the necessity for patience effectively to clients.

Perhaps an en masse, industry-wide move away from daily dealing would precipitate greater investor acceptance that capital must be locked away in a dark room for extended periods to grow.

©2016 funds europe