This month marked one year since the collapse of Neil Woodford’s LF Woodford Equity Income fund. The Woodford fund was suspended in June, after it became overwhelmed by redemption requests from investors.
One year on and investors are still awaiting their final pay-out.
One year on and questions concerning the liquidity mismatches in open-ended funds still remain.
Liquidity Risk Issues in Real Estate Funds and Funds of Funds Sectors
ESMA published a report in early 2020 which found that Fund of Funds and Real Estate Funds, despite being the two sectors with the largest percentage of retail investors (FoF: 31%, Real Estate: 21%), are also the sectors with substantial liquidity issues.
The liquidity vulnerabilities of Real Estate Funds that offer daily liquidity are well documented, however, an ESMA report also found that for the Funds of Funds sector there is also a mismatch in liquidity, as 35% of the NAV is redeemable within a day, while only 24% of assets can be liquidated within that timeframe.
COVID-19 has exacerbated the liquidity mismatch issue and if possible, brought it even further to the forefront. Following the unprecedented challenges brought by the pandemic, we saw a wave of UK open-ended property fund suspensions trapping almost £13 billion of investor cash. Standing independent valuers determined that there was “material uncertainty” over the value of commercial real estate (CRE).
Due to the suspensions, the FCA published a statement stating “suspensions can be used by managers of open-ended funds, in line with their obligations under applicable regulations. In these circumstances, suspension is likely to be in the best interests of fund investors”.
“At least USD62 billion of global mutual funds have suspended redemptions this year to date due to coronavirus-driven market stress” – Fitch Ratings
Increased Scrutiny during COVID-19
The liquidity mismatch is not confined to the UK. Heavy redemptions during the COVID-19 induced sell-off sparked concerns amongst Regulators across Europe, who subsequently increased the scrutiny on the liquidity of asset managers in varying manners.
In Luxembourg, the CSSF introduced a weekly questionnaire, the objective of which is to provide the CSSF with weekly updates on financial data (total net assets, subscriptions and redemptions) and an update on governance arrangements in relation to the activities performed by IFMs.
In France, the AMF issued a reminder to AMCs of their obligations to put in place adequate and effective arrangements, procedures, and techniques to measure and manage at any time the liquidity risks which the UCITS and AIFs they manage are, or might be exposed to. The AMF went on to state that AMCs that breach investment restrictions or experience liquidity difficulties and have to activate certain liquidity management mechanisms (gates, side pockets, suspension of subscription and redemption orders, etc.) must notify the AMF on a daily basis.
In January 2019, in response to Brexit preparedness, the Central Bank increased its monitoring of investment funds liquidity and redemption activity. This involved putting in place arrangements for the collection of new data or increasing the frequency of collection of certain information. These arrangements have remained in place during the COVID-19 pandemic and in some instances have been supplemented.
In Germany, liquidity tools are enshrined in the German Capital Investment Code (KAGB) and were expanded by Article 5 Federal Law Gazette. The new liquidity tools have long been at the disposal of fund managers in other EU countries and includes redemption notices and swing pricing. It also been reported by the FT, that BaFin has been holding daily calls with managers of retail funds categorised as having the “most critical liquidity risk status” to discuss measures to mitigate the situation.
Addressing the Mismatch
Edwin Schooling Latter, FCA Director of Markets and Wholesale Policy recently gave a speech to the Association of Investment Companies. In his speech, Mr Latter discussed the continuing work by the FCA and Bank of England (BoE) to evaluate the costs and benefits of possible policy measures to achieve greater consistency of fund redemption terms with the liquidity of funds’ assets.
In his speech, Mr Latter explored measures used to address liquidity issues, including:
- Asset Restrictions;
- Swing Pricing; and
- Notice Periods
Restricting the assets in which funds that offer daily dealing may invest is one method currently used by regulators. UCITS funds may only hold 10% of assets in illiquid securities. However, as noted by Edwin Schooling Latter these restrictions also act to the detriment of investors due to the premium paid for liquid assets resulting in lower expected returns compared to less liquid assets.
In his speech he discussed the reluctance of the FCA to impose additional restrictions on investments in illiquid assets as this would unlikely be the best solution for fund investors or the wider economy.
He did however state that the FCA are looking to review the UCITS rule that creates a presumption – unless there is information to the contrary – that listing on an exchange means an asset is sufficiently liquid to meet short-notice redemption requests. Some listed assets are still illiquid.
An alternative to restrictions on the assets is swing pricing. For those less familiar with the concept, it is a liquidity management tool that allows fund managers to adjust the fund’s NAV per share to reflect the estimated costs associated with investor redemptions and subscriptions. These costs arise whenever the fund manager needs to sell or buy assets in order to meet redemption requests or invest cash inflows.
Swing pricing is already allowed in the UK and can mitigate the first-mover advantage by levying the dilution costs on withdrawing investors.
Another remedy Mr Schooling Latter discussed was the use of notice periods whereby investors must give the fund manager notice if they intend to redeem investments from the fund. This could be weeks or months between the point at which a redeeming investor submits a redemption request and the subsequent pricing and execution of that transaction.
Notice Periods provide flexibility to the fund allowing it to meet redemption requests without having to sell assets at a discounted fashion. They are arguably a simpler way of promoting investor understanding of the risks associated with investing in less liquid assets through an open-ended structure, and reduce the likelihood of redemption requests at times of market stress.
Overall, the FCA want open-ended funds to provide a structure through which investors can safely invest in less liquid assets which offer attractive expected returns and which supports investment that benefits the wider economy. Recent experiences may help rational and well-advised investors to recognise that daily redemption funds are unlikely to be the safest, or most profitable way of investing in less liquid assets. The FCA feels that now is the right time to address this, and make progress on embedding the right structures for open-ended funds investing in such assets.
Other matters covered included how any changes would be implemented for existing funds, as well as a consideration of a possible internationally harmonised approach to liquidity risk. Mr Schooling Latter also stressed that ultimate responsibility to ensure that obligations to investors are fulfilled lies with the senior management of relevant firms, particularly in light of the Senior Managers and Certification Regime.
The liquidity mismatch is clearly not a new issue within the industry. From a regulatory perspective, both the UCITS Directive and AIFMD have various requirements in relation to liquidity management which are designed to mitigate this risk, as does the Money Market Fund Regulation discussed in our previous blog.
It is also clear that addressing fund liquidity issues is at the core of ESMA’s activities. Earlier in the year, ESMA launched a Common Supervisory Action (CSA) with national competent authorities (NCAs) on the supervision of UCITS’ managers liquidity risk management across the European Union. Additionally, later this year in September the Liquidity Stress Test guidelines for UCITS and AIFs enters into force. So to do the ESMA Guidelines on Stress Test Scenarios under the MMF Regulation, which requires MMF Managers to report their quarterly reports for both the Q1 and Q2 reporting periods.
To assist mangers with their liquidity risk management monitoring, our automated solution is designed to meet international requirements in respect of liquidity risk management and liquidity stress testing. It is a holistic solution which embeds liquidity risk management into product governance, throughout the product lifecycle.