Liquidity risk management in investment funds has come sharply into focus recently. The European Securities and Markets Authority (ESMA) consulted upon and released guidelines on the performance of liquidity stress tests (LST) in September and released their own stress test analysis. Further, in Ireland, the Central Bank of Ireland (CBI) wrote to fund management companies reminding them of their obligations in relation to liquidity risk.
What is Liquidity Risk?
Liquidity generally describes the ability to pay debts when they are due. If you can’t raise enough cash to pay your bills, regardless of the assets you own, you will become insolvent. In the context of investment funds, liquidity is generally seen as the ability to fulfil redemption orders when requested.
Mutual funds can face a mismatch between the assets they own and the demand of investors to redeem their capital. The majority of UCITS funds offer their shareholders the ability to subscribe or redeem their capital daily. If the assets held within the fund cannot be sold quickly to meet redemption requests, there could be severe issues in paying redeeming investors. This can be exacerbated in times of stress when investors may look to redeem en masse whilst the market for the assets is drying up.
What Should Fund Management Companies be Aware of?
Both the UCITS and AIFM directives require fund management companies to assess and manage the liquidity risk of the funds under management, and to perform appropriate stress testing. Whilst ESMA’s guidelines on liquidity stress testing come into effect from 30 September 2020, UCITS1 and AIFMs2 are already obliged to perform stress tests at least annually.
Assessing the Liquidity Profile
Fund management companies should review their funds under management to understand the specific liquidity risk faced.
Assets are generally assessed based on two criteria: time to liquidate and cost to liquidate. Generally, this will involve dividing the position held against an average market trading volume (usually 30-day average volume) to calculate a days-to-liquidate figure. Simultaneously, the bid/ask spread on the asset should be reviewed to establish a cost to liquidate. Assets are then categorized (e.g. highly liquid, liquid, illiquid etc.) based on a combination of time and cost to liquidate.
Liabilities should be assessed by looking at the nature of the liabilities of the fund. For example, a highly-concentrated investor base may present the risk that a large portion of the fund may be redeemed on a single day. Similarly, high investor turn-over numbers may indicate the need to hold a liquidity buffer to meet redemptions without incurring additional dealing costs.
While liability focus is generally on potential redemptions, a fund management company should not overlook other liabilities. For example, a fund investing in derivatives may face a large margin call in volatile markets. Equally, a closed-ended fund will still have to manage enough cash to cover its running expenses.
The fund management company must assess the available tools to help manage liquidity. The arrangements for investors to redeem should be proportionate to the investment objectives of the fund. Daily dealing may be appropriate for a retail-focused long-only large-cap equity fund but would not be appropriate for an AIF-focused on long-term property development. Funds may also be able to manage redemption liquidity by agreeing with investors to redeem assets in-kind.
Further, many fund documents will permit controls on redemptions such as ‘redemption gates’ where redemptions are limited to a percentage of assets on each dealing day. This control allows fund management companies to spread larger redemption requests over a longer period of time in order to raise funds in a controlled manner. In extreme circumstances, it may be possible to suspend dealing in a fund. However, there may be substantial reputational harm if dealing is suspended. These controls must be clearly articulated in the fund’s prospectus or offering documents.
When fund management companies have established a liquidity risk profile for each fund, they should look to implement appropriate policies to manage the risk. The policies should address how portfolios will be liquidated if required, e.g. a waterfall approach selling the most liquid assets or a pro-rata slice of the portfolio. In such situations, there should always be an assessment of the impact to remaining fund investors, while keeping in mind that any regulatory restrictions will continue to apply.
AIFs and UCITS are required to stress test their liquidity risk management process at least annually. However, ESMA recommends a quarterly testing program. In some situations, it may be more appropriate to stress test more frequently, such as during periods of ongoing redemptions or periods of limited market activity.
Stress tests should combine historical events, hypothetical situations and reverse stress tests. Some examples may be:
- The 2008 financial crisis;
- A 50% reduction in average daily volumes;
- A 100-basis point widening of spreads; or
- A 50% redemption from the portfolio.
The results of these tests should be used to inform portfolio managers and fund management companies managing fund liquidity on a day-to-day basis.
Governance and Oversight
The boards of fund management companies are responsible for managing the risks faced by the funds under management. The board should receive reporting from the fund management company as to the liquidity profile and the results of liquidity stress tests. The board should determine if the measures outlined in the liquidity risk management process are appropriate for the nature, scale and complexity of the funds under management.
ESMA also places an obligation on depositaries to verify that liquidity stress tests are performed. There is no expectation that depositaries will review or challenge the result of such tests.
Fund management companies should fully document their liquidity risk management process in their risk management policy.
Duff & Phelps provides a suite of solutions to enable asset managers, investment funds and fund management companies to understand their market and regulatory risks, including liquidity risk management and stress testing.
1 Commission Directive 2010/43/EU
2 Commission Directive 2011/61/EU