Investors are drawn to funds with the promise of liquidity, the ability to readily access their capital. They trust fund managers to uphold this promise, ensuring redemption requests are met promptly, regardless of market volatility. This trust hinges on robust liquidity risk management, a cornerstone of financial regulation and a key factor in our assessment of fund operations.
The financial landscape has evolved considerably since the 2008 crisis, presenting new challenges to liquidity management. The persistent low interest rate environment has fueled a relentless pursuit of yield, pushing investors towards fixed-income securities with lower credit ratings. These securities, often traded over-the-counter (OTC), typically exhibit limited liquidity, creating a potential mismatch for funds offering frequent, often daily, dealing.
Our observations reveal a positive trend: fund managers are rising to the challenge, proactively reviewing and refining their liquidity management practices. They are adapting to evolving market conditions, ensuring their portfolios can consistently meet redemption obligations and align with the expectations of their investor base. These proactive measures are consistent with the principles outlined in the International Organization of Securities Commissions (IOSCO) document, “Principles of Liquidity Risk Management for Collective Investment Schemes,” a valuable resource for industry best practices.
Transparency is Key: Disclosing Liquidity Risks to Investors
It’s no secret that a gap often exists between the liquidity promised in fund prospectuses and the actual liquidity of the underlying securities. This is where skillful liquidity management becomes paramount. Effective management aims to bridge this gap, mitigating risks and ensuring investors can confidently redeem their investments.
Transparency is paramount. Investors, as the ultimate bearers of liquidity risk, must be well-informed about the nature and scope of these risks. Fund documentation should clearly articulate these risks, empowering investors to make well-considered decisions, especially during turbulent market periods. A deep understanding of liquidity risk can help mitigate panic selling, a phenomenon that can exacerbate liquidity challenges.
Effective disclosure of liquidity risk should encompass:
- Volatility Impact: Clearly communicate how the liquidity profile of portfolio holdings can impact the volatility of fund returns.
- Exceptional Measures: Explain the potential use of tools or exceptional measures that might affect redemption rights. Describe the circumstances under which such measures would be employed and their potential impact on investors.
- Tools and Their Impact: Provide a clear description of the specific tools and measures at the fund manager’s disposal and their potential consequences for investors.
Best Practices: Building a Solid Liquidity Risk Management Framework
The firms we’ve reviewed demonstrate a commitment to robust liquidity risk management through a range of processes and tools tailored to the unique characteristics of their funds and investment strategies. Their best practices provide valuable insights for the industry:
- Alignment of Dealing Arrangements: Aligning fund dealing arrangements (subscriptions and redemptions) with the investment strategy is crucial. This alignment should be assessed throughout the fund’s lifecycle, ensuring redemption requests can be met consistently. For example, during the product design phase, the dealing frequency should be carefully evaluated against the proposed investment strategy and portfolio composition. Similarly, periodic reviews of existing products should assess whether the dealing timetable remains appropriate, especially in light of any significant changes in the liquidity characteristics of underlying securities.
- Proactive Liquidity Demand Assessment: Regularly assessing liquidity demands, including redemptions, collateral calls, and other fund obligations, is essential. This assessment should involve developing a range of potential redemption scenarios and evaluating risks. Factors to consider include the composition of the investor base, historical net fund flows, and the experience of similar funds.
- Continuous Portfolio Liquidity Assessment: Accurately assessing the liquidity of portfolio positions is critical. This can be challenging, especially for assets like infrequently traded corporate bonds. Leading firms utilize a combination of sources, including external data feeds and insights from internal trading functions, to arrive at reliable liquidity estimates. Given the dynamic nature of liquidity, these assessments need regular updates to reflect changing market conditions.
- Liquidity Buckets and Limits: Employing liquidity “buckets” is a common practice. These buckets categorize holdings based on their estimated disposal time, often classified as “high,” “medium,” or “low” liquidity. Limits are then set to manage the total portfolio exposure to each bucket. These limits should be dynamic, adjusted periodically to adapt to evolving market conditions.
- Independent Risk Monitoring: An independent risk function plays a crucial role in monitoring portfolio exposures against established liquidity buckets. This function reports any breaches to the set limits, enabling timely intervention. Leading practices include implementing “hard” limits, requiring immediate action to address breaches, and “soft” limits, allowing for position review and limit overrides with appropriate approvals.
- Stress Testing for Resilience: Stress testing is a vital tool for assessing the impact of extreme but plausible scenarios. Fund managers use stress tests to evaluate the potential effects of various factors, both individually and in combination, on their ability to meet redemption requests. These factors often include:
- Redemption Volume: Funds are tested against various redemption scenarios, ranging from historical experience to extreme but plausible events, to understand the impact on trading timeframes and investment performance.
- Market Volatility: Funds are tested against simulated market stress conditions that could significantly impair their ability to transact with other market participants, revealing vulnerabilities and potential mitigation strategies.
Best Practices: Ensuring Fairness in Fund Dealing
Effective liquidity management extends beyond portfolio construction and risk assessment; it includes how funds manage redemptions and associated transaction costs. Mishandling these aspects can inadvertently incentivize early redemptions, potentially triggering a “run” on the fund and exacerbating liquidity challenges.
Best practices prioritize the interests of all investors, minimizing costs associated with redemptions and shielding them from adverse portfolio changes. These practices underscore a commitment to fairness and transparency, assuring investors that their interests are paramount. By removing any perceived “first mover advantage,” where early redeemers benefit at the expense of others, these practices discourage panic selling and contribute to a more stable fund environment. Openly communicating these practices to investors is crucial for building trust and confidence.
Let’s delve into some examples of good practice in fund dealing:
- Portfolio Adjustments for Liquidity: Maintaining the desired level of portfolio liquidity after a significant redemption is crucial. A “vertical slice” approach, where sales are executed proportionally across asset classes, can help preserve the portfolio’s overall liquidity profile, ensuring remaining investors are not disadvantaged.
- Governance for Investor Protection: A well-defined governance process is essential for protecting the interests of all investors. This process sets clear guidelines for implementing exceptional liquidity management tools, such as swing pricing or deferred redemptions, ensuring these measures are used judiciously and transparently. This typically involves establishing a threshold for net redemption flows that trigger such measures and empowering a committee, independent of portfolio management, with the final decision-making authority. This separation of duties prioritizes investor protection.
Preparing for Exceptional Circumstances
While most funds have not needed to resort to exceptional liquidity tools like swing pricing, deferred redemptions, or suspension of dealing, preparedness is paramount. These tools act as safeguards, protecting investors during periods of extreme market stress.
Leading firms demonstrate their commitment to preparedness through:
- Detailed Procedures Manual: Maintaining a comprehensive procedures manual that outlines the steps for implementing each exceptional tool or measure. This manual clarifies the roles and responsibilities of all parties involved, ensuring a coordinated response.
- Operational Readiness: Regularly testing and rehearsing the operational aspects of implementing these tools to ensure they function as intended in real-world scenarios. This often involves simulated exercises under stress conditions.
Conclusion
In today’s dynamic investment landscape, characterized by evolving risks and market uncertainties, a robust approach to liquidity risk management is not just good practice; it’s essential. The insights shared in this document, drawn from observations of leading investment management firms, offer a roadmap for enhancing liquidity risk management practices.
We encourage firms to focus on three key areas:
- Continuous Evaluation: Tools, processes, and underlying assumptions should be continuously reassessed and updated to ensure they remain relevant and effective in response to changing market conditions.
- Operational Preparedness: Maintaining a high degree of confidence in the operational readiness of all liquidity management tools, especially extraordinary measures, is crucial. This involves regular testing, training, and refinement of procedures.
- Transparent Disclosure: Clear and comprehensive disclosure of liquidity risks to fund investors is paramount. This includes providing detailed information about the tools at the fund’s disposal, such as swing pricing, deferred redemption, and suspension of dealing, and the circumstances under which they might be used.
By embracing these principles and adapting them to their specific context, firms can strengthen their liquidity risk management frameworks, reinforcing investor trust and contributing to a more resilient and stable investment ecosystem.
