Answer three questions to protect your fund and your clients from liquidity risk
Recent issues have highlighted the need for stock liquidity risk management. Here are 3 questions to help you get started.
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Recent issues with specific funds have brought to light the pressing need for fund managers to manage their risk when it comes to stock liquidity.
Retail clients in particular want and expect to have their money available to them on a daily basis.
If the stocks in a fund cannot be sold quickly enough to meet the clients’ demands then investors will use the cash that is within the fund vehicle. After some time the amount of cash will be used up and investors will not be able to get their money.
Currently the FCA has no rules governing the management of liquidity risk, with the EU Undertakings for Collective Investment in Transferable Securities (UCITS) directive setting a 10% cap on the amount of unlisted stock a fund can hold. In the past the FCA has provided guidance and issued a consultation paper but many firms may not be clear on the expectations.
What you need to do
To maintain the integrity and sustainability of your fund and protect your clients, you should carry out stress testing on the liquidity of the assets in the fund. You also need to examine the expected level of investor redemptions based on previous stress events. This will help make sure the appropriate amount of cash or liquid assets are held in the fund.
Here are three simple questions to ask to get started.
1.What assets does the fund actually have?
Despite UCITS rules assigning caps to the percentage of unlisted stock, there’s sometimes a lack of detailed oversight of the unlisted stocks. This is causing real blind spots that can lead to funds being suspended or gated. Sometimes this can be due to firms classifying assets incorrectly, either by accident or because they don’t have a full understanding or appreciation of the rules.
Manage your risk by reviewing the amount of illiquid assets in true context. This means you should be considering the volume of illiquid assets held, rather than just the percentage they occupy as a part of the full portfolio.
Despite UCITS rules assigning caps to the percentage of unlisted stock, there’s sometimes a lack of detailed oversight of the unlisted stocks”
2.Who are the fund’s investors?
Are your investors institutional or retail? Retail investors are likely to be less experienced and more prone to herd behaviour in the event that fund performance is low. They’ll often have a need and desire to turn investments into cash very quickly compared to institutional investors. The need for investors to turn their investments into cash may not match with how quickly the asset can be sold.
What’s more, retail investments can only be invested in UCITS funds which should have a certain amount of liquidity. This is compared to a hedge fund, with longer intervals between when a fund can be bought into or sold.
It’s worth reiterating that institutional investors in a retail fund do have the power to quickly withdraw their investments, even though they’re large. For example, a local authority making the decision to withdraw its £263m pension fund.
3. How will you shift the fund’s assets?
Have a plan in place for how you would sell off assets to meet demand if needed. You must consider the liquidity of the stock in your funds, and when and how investors might want to redeem.
Redemption gates are allowed under the rules but do not provide great customer outcomes even when disclosed in advance. Active liquidity management is always a better tool.
As funds grow, the percentage of illiquid assets grows cumulatively. The greater volume of illiquid assets in the fund the more difficult it will be to get rid of the illiquid assets. Therefore firms will have to amend their holdings or hold more cash.
Take the opportunity
None of these points should come as a surprise, and yet scenarios like this are currently playing out in the real world. Take this opportunity to make sure these risks are managed in your own firm, developing frameworks to protect your future.
The governance of the liquidity management process and the involvement of risk management teams is absolutely crucial in moments of stress. You should also make a point of disclosing to investors the liquidity management tools they have available to use.
Fortunately we can be on hand to help you create liquidity risk management solutions that are ideally tailored to your business. We have practical experience in this area as well as a deep appreciation of the rules.
Find out just how we can help by speaking to an expert today.