Illiquidity: a sticky question for funds

Many investors are aware of the potential drawbacks when they allocate to illiquid strategies. But others have allocated to illiquid assets in search of higher returns without sufficient knowledge of the pitfalls.

The main problems evidenced so far stem from funds offering same-day liquidity to clients while investing in asset classes that have less liquidity. Less obvious is the potential illiquidity risk of ordinary equity and bond funds, which in theory invest in deep markets and can easily buy and sell assets whatever the market conditions.

But even in these funds, liquidity risk exists and can be triggered by large redemption requests or other cash outflows. Today’s corporate bond investors will only find out if they are really holding liquid assets if there is an unexpected rise in interest rates.

Most fund managers make considerable effort to manage liquidity risk despite the difficulties in defining and measuring liquidity.

It is not an easy task: each fund has its own characteristics, investment objectives, portfolio holdings and investor base. No one-size-fits-all approach can govern every fund’s liquidity needs.

So liquidity management is a constant and evolving area of focus for funds. Managing liquidity is a dynamic collaborative process that features qualitative and quantitative contributions from several areas in a fund organisation, including portfolio managers, traders, risk officers and analysts, legal and compliance personnel and senior management.

One tool helping fund managers to improve their transparency is Euroclear’s e-Data Liquidity solution. This provides fund managers with snapshot of settlement activity within the Euroclear system, which covers more than 40,000 high-turnover assets. The tool enables managers to make quick and informed decisions on the liquidity of the portfolio, and facilitates regulatory reporting and compliance.

Although most investment firms take liquidity seriously, in the current era regulators are not inclined to leave the issue to chance.

Regulators in Europe have strict rules governing liquidity management in UCITS funds. A UCITS fund can, for instance, invest no more than 10% of its assets in unlisted securities, can invest no more than 10% in other investment funds, and so on.

Meanwhile, in the US, the SEC is currently proposing liquidity risk management requirements for open-end mutual funds and ETFs.

The proposal calls for funds to estimate the number of days needed to sell each of their holdings, and then place those holdings into buckets from most liquid to least.

Despite best efforts, perhaps the truth is that funds and regulators will never be able to measure or control liquidity with any great accuracy. But they should nevertheless strive to refine their processes. A number of ideas have gained traction.

One of these is gating, which temporarily limits investors’ ability to withdraw their money in times of market stress. If gating is imposed early, it effectively closes the fund, protecting remaining investors.

European UCITS funds and hedge funds already have the ability to gate, and gating has also been introduced as part of the reform of money market funds in the US. However, US mutual funds do not currently have this power.

Second, funds investing in illiquid assets but which offer daily trading could switch to monthly, or even quarterly, trading periods. However, this does not always fix liquidity mismatches, because some assets take far longer to liquidate than a month, or even three months.

Third, some have suggested banning retail investors from open-ended funds which have allocations to illiquid assets. To do this would require fund managers to have complete transparency over their investor base. Euroclear’s funds processing platform gives clients the ability to segregate their holdings at various levels, providing fund managers with a clear view of who their investors are, and enabling KYC checks. 

Another possibility is that regulators could demand that stronger, clearer warnings are applied to certain funds. However, the FCA and its counterparts have a long list of existing priorities, so they are unlikely to act with haste.

Given the lack of certainty, it is incumbent on investors to rely on their own judgement, and not entrust the liquidity issue to either fund managers or regulators.

In the final analysis, investors may just have to accept that by investing in open-ended funds containing illiquid assets, they may not be able to access their assets at times of market stress.

They need to recognise that these funds represent the least liquid parts of their portfolio, and that they should have an inventory of more liquid assets that can be sold rapidly in case of future cash flow needs.

This is not to suggest that the investment industry can wash its hands of the issue. The next crisis will probably not look like the last crisis, but liquidity will almost probably be the first victim of it. Both funds and their investors have a part to play in mitigating this risk.