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Liquidity - The biggest issue for 2020

Published by Charles Gubert

Liquidity As returns on traditional investments declined, a handful of fund managers sought out illiquidity premiums by accumulating exposures to hard to sell assets.  While such an investment approach can be justifiable under some circumstances, it can be quite risky as a number of retail and institutional clients discovered to their misfortune in 2019, many of whom remain trapped in funds which were originally sold to them as being daily dealing.

The Woodford Equity Income Fund – for obvious reasons – was the best documented example of investors being left unable to access their capital after it was revealed that a lot of the fund’s holdings were illiquid despite it being marketed as a UCITS.  A daily dealing property fund operated by M&G was also forced to gate amid tough market conditions, bringing back memories of Brexit, when some similarly structured investment vehicles put a stop to customer redemptions as real estate prices plummeted after the referendum result.  

Since the Woodford collapse unfolded, the FCA has introduced protections for allocators investing in illiquid assets through open ended funds. While the rules do not apply to UCITS but non-retail UCITS schemes, they will oblige managers of such investment vehicles to provide clients with “clear and prominent” information on liquidity risks and the circumstances in which access to their funds may be restricted. The provisions also stipulate that managers investing in illiquid assets should have plans in place to mitigate liquidity risk. In addition, open ended property funds could be forced to cease trading if there is material uncertainty over the value of 20% of their underlying assets in rules due to go live in 2020.

At an EU-level, the European Securities and Markets Authority (ESMA) is now demanding that managers of UCITS and AIFs conduct liquidity stress tests, including the impact that mass redemptions would have on their portfolios. The liquidity stress test programmes must be documented by managers and corroborated by their depositary. Nonetheless, the EU’s rules are widely seen as being less rigorous than the stringent liquidity risk management obligations imposed on mutual funds in the US by the Securities and Exchange Commission.

Even though ESMA recently warned member state regulators against implementing large-scale changes to the UCITS regime following the Woodford episode, the authorities in the UK and Ireland believe decisive reform is needed.  The UK’s FCA and Bank of England (BOE) both said liquidity mismatches need to be prevented with the latter going so far as warning that open ended funds could even be a source of systemic risk. In its Financial Stability Report, the BOE recommended investors in funds holding illiquid assets be refused immediate access to their cash or alternatively forced to incur a discount on  withdrawals.

Industry associations have tried to come up with their own solutions. The Investment Association (IA) has proposed a framework for a long-term asset fund, a structure that would put an end to daily redemptions at investment vehicles trading in illiquid assets in what it hopes will minimise the risk of liquidity mismatches. Quite what UK (or Irish) regulators will expect from UCITS moving forward is unknown.  In the context of recent events, it is probable the FCA and BOE will take a much tougher line on fund liquidity terms.