For some time now regulators across the globe have been sharply focused on the liquidity of investment funds. More specifically, policymakers have homed in on those funds that sell to retail investors and purport to be capable of returning investors their money daily (i.e. daily dealing open-ended investment funds). In the investment funds world, the generally accepted definition of illiquid assets is those that cannot be sold in current market conditions within seven calendar days without significantly changing the market value of the investment. Daily dealing funds such as UCITS generally hold very few illiquid assets
The profile of this issue has increased significantly in recent months due to the reporting of some high-profile UCITS funds having liquidity difficulties. It seems even regulators have differing opinions about the best way to rectify liquidity mismatches.
Some of the aforementioned high-profile funds, facing an influx of redemption orders, chose to suspend dealing and inform their regulators that they were unable to redeem investors upon request because they held a chunk of illiquid assets that could not be sold in short order. It is this mismatch of underlying liquidity of the funds’ portfolio and the redemption frequency of the fund which is subject of scrutiny.
UCITS are predominately open-ended daily dealing funds although the UCITS rules explicitly permit funds to provide for longer redemption terms. The recent liquidity events have resulted in some people asking the question whether the UCITS rules need to change. In the US, the SEC Liquidity Rule requires open-ended funds to classify their investments in four buckets based on their time to liquidation and are ranked as either highly, moderately, less liquid, and illiquid. There can be no more than 15% of the fund invested in the illiquid bucket.
Despite recent issues, open ended retail investment funds in the US and Europe generally operate to high standards to ensure investor liquidity. UCITS rules are also explicit that “the liquidity of an instrument must not compromise the ability of the UCITS to meet its repurchase (of investor shares) obligations.” UCITS must stress test liquidity risk already as part of their risk management process: in the case of the recent high-profile redemption suspensions, the non-enforcement of the existing ruleset seems to have played more of a part in these events than a sub-optimal ruleset.
It is critical to remember that not all funds are alike and carry the same liquidity risks: risks and events giving rise to liquidity issues may be unique, specific, and idiosyncratic to specific types of funds, strategies, asset classes, and asset mix. In summary, when looking at global fund liquidity we must not throw the baby out with the bath water. The focus should be on whether the rules need to be upgraded or whether the recent events occurred because the rulesets in place were not adequately followed.
Fund Liquidity Debate Timeline: A Brief Recent History
The liquidity issue has evolved significantly in the past 24 months. Let’s consider recent regulatory events related to fund liquidity:
Regulators at Odds on Liquidity
While the Woodford case made UK policymakers (the FCA and Bank of England (BoE)) take notice and speak out on the requirement to bolster existing fund liquidity rules, other European and global regulators have taken a different tact. Other regulators take the view that the existing rules and work done in this area are enough. For instance, in the US, the SEC has already enshrined their Liquidity Rule.
The regulatory difference of opinion became apparent after Mark Carney, governor of the BoE, claimed that open ended retail funds were “built on a lie.” The president of industry body ICI then characterised Carney’s comment as showing a “poor understanding of fund managers, fund investors or fund regulation” A subsequent report by the Financial Policy Committee (FPC) of the BoE stated:
“This is a global issue. For that reason, the FPC supported the Financial Stability Board’s 2017 recommendation that funds’ assets and investment strategies should be consistent with their redemption terms. However subsequent work by IOSCO did not prescribe how this should be achieved."
IOSCO then issued a rebuttal on July 18, referring to the FCP publication and the “extensive media coverage” it had received. IOSCO reiterated its belief that “the recommendations do in fact provide a comprehensive framework for regulators to deal with liquidity risks in investment funds,” referring to factors such as asset to redemption alignment, swing pricing, fair value pricing, fund suspension, and gating tools. The IOSCO paper also urges regulators to use caution and be acutely aware of the difference between wider systemic issues and whether a particular liquidity issue is fund-specific or idiosyncratic.
Broader Questions Raised
Do open ended investment funds create systemic risk?
The fund liquidity debate has ignited additional, corollary policy debates. One spin-off discussion has been whether investment funds create systemic risk concerns at all. Some commentators, including Carney, suggest that fund liquidity in stressed market conditions has the potential to create issues for other parts of the capital markets and banking system. The FSB previously tried to label large asset managers as systemically important, but this rested on the basis that funds bear no principal risks and generally do not operate like banks. In any case, this debate – like many others in financial services – should not be considered resolved.
Will UK and global regulators diverge post-Brexit?
The investment fund liquidity debate has seen different interpretations of the issue particularly as between UK policy makers and other national and global bodies. There has been much debate in the context of a post-Brexit world about whether or not the UK would look to stay closely aligned to the EU on regulatory standards or whether it would look to diverge and forge its own regulatory ecosystem.
Should retail investors have access to less liquid higher yielding asset classes?
There have been global policy attempts to bridge the mismatches between fund liquidity, redemption cycles, and investment returns to the benefit of retail investors. One such project has been the European Long-Term Investment Funds (ELTIFs). The ELTIF framework offers a framework for broadening the availability of illiquid assets beyond large institutional investors to include potentially retail investors across the EU. To date, ELTIFs have struggled to find a balance between long-term financing stability needed for investment in suitable assets, such as property and infrastructure, with the liquidity needs of retail investors.
In the US, SEC Chairman Jay Clayton recently outlined a desire to overhaul certain retirement asset rules which would make it easier for individual retail investor to invest in private companies and initial public offerings (IPOs). This is a recognition of the fact that retail investors are often discounted from such higher risk, higher yielding investment opportunities for investor protection reasons.
Ironically, given the FCA comments around the Woodford case, one of the few markets that currently allows retail investors access to highly illiquid investments is the UK. There is a large and vibrant real estate investment trust market in the UK. However, this came under scrutiny around June 2016 when several UK retail property funds were suspended after the country’s vote to leave the EU. This left more than £18 billion frozen in the biggest seizing up of investment funds since the 2008 financial crisis.
The fact that the Woodford fund remains suspended and the ESMA consultation on stress testing of fund liquidity is not yet concluded, you can be sure that fund liquidity – and related issues – will remain the subject of regulatory focus for the foreseeable future. It is most important that changes, if any are proposed, are proportionate to the matters at hand and serve to better accommodate investor needs.