Liquidity Management Tools in Open-Ended Investment Funds: The Right Tools in the Right Hands?
Liquidity risk in investment funds and its potential systemic consequences have risen on the policy agenda over the last few years. Most recently, the European Commission adopted a proposal for a review of the Alternative Investment Fund Managers Directive (‘AIFM Directive’) and the Undertakings for Collective Investment in Transferable Securities Directive (‘UCITS Directive’), with liquidity risk management featuring as a central component. Regulators’ growing attention follows a series of high-profile liquidity crises. In 2016, following the Brexit referendum, significant outflows forced some of the UK’s biggest commercial property funds to suspend the redemption rights of their investors. In 2018 and 2019, three asset managers—more specifically GAM, Woodford, and H20—made headlines because their funds experienced significant outflows due to a combination of poor past performance and a decrease in the fund portfolio’s liquidity. During the financial turmoil resulting from the initial COVID-19 outbreak at the beginning of 2020, the tightened liquidity in the market combined with significant redemption requests by investors put pressure on the fund industry. While the majority of funds were able to meet redemptions, around 140 EEA-domiciled investment funds had to suspend redemption between March and May 2020 due to valuation uncertainty or outflows. From the beginning of April 2020, the interventions of central banks helped restore balance in the market and liquidity improved.
There are particular concerns about liquidity risk in open-ended investment funds. An open-ended fund is a fund that does not have a set amount of assets under its management. Depending upon investors’ demand, the fund will issue or redeem shares/units on a continuous or periodic basis. This open-ended nature can create liquidity risk when a position in a fund’s portfolio cannot be liquidated at limited cost and in an adequately short timeframe in order to fulfil a redemption request. Managers will either need to have liquid reserves in place or face liquidity risks resulting from portfolio rebalancing to free up the cash necessary to meet redemption requests. In other words, manager will need to match the liquidity of the asset and liability side of their balance sheet in order to avoid liquidity problems. Moreover, certain characteristics of open-ended funds could encourage a run on funds by investors in crises times, amplifying liquidity problems and their consequences for the stability of the system as a whole. In particular, first-mover advantages in open-ended funds arise when the costs of redemptions are partly borne by the remaining investors. Empirical evidence supports the existence of first-mover advantages in open-ended funds with illiquid assets.
Policymakers have stressed the importance of the adequate use of liquidity management tools—such as pricing arrangements, notice periods, and suspension of redemption rights—to manage liquidity mismatches and its destabilising consequences for investors and the system as a whole. In a recent article, I examine the allocation of the decision-making power over the design and application of liquidity management tools in open-ended funds. In most jurisdictions, the decision to apply liquidity management tools is in the first place the responsibility of the asset managers, who tend to have discretionary powers to assess the necessity of such measure. However, in recent years, there have been proposals to use liquidity management tools as part of the macroprudential toolkit available to prudential authorities.
The article argues that asset managers tend to be best placed to apply liquidity management tools, especially if the application of the liquidity management tools requires micro-level or fund-specific information. More specifically, asset managers will focus on strong fund performance, liberal redemption rights, and maintaining a good reputation in order to attract investors. During a crisis, they will want to avoid disruption to the investors’ rights as well as ensure that they manage investors’ perceptions. They will also have the best access to fund specific information. The article shows that these incentives are often aligned with maintaining financial stability. Swing pricing, for example, is a widely-used liquidity management tool where the net asset value (‘NAV’) of the fund is adjusted by a ‘swing factor’, ie the percentage by which the NAV is adjusted to reflect transaction costs. Swing pricing protects the remaining fund investors and encourages the redeeming investors to spread their redemption requests over time. There is increasing evidence that the use of swing pricing could mitigate first-mover advantages and run incentives of fund investors. Swing pricing will therefore be beneficial for financial stability, as it will reduce the risk of destabilising fire sales of illiquid assets in the market during a run. Asset managers, however, also have strong incentives to use swing pricing. Indeed, swing pricing can prevent the dilution of fund performance by limiting the cost of fire sales due to runs. In other words, swing pricing can have a positive impact on fund performance and therefore future inflows. In addition, asset managers are also best placed to apply swing pricing, as they have access to the necessary fund-specific information.
However, in specific circumstances, the incentives of asset managers are not aligned with the interests of the financial system as a whole. In particular, asset managers will not apply liquidity management tools if they would suffer reputational damage, can externalise the costs on the financial system as a whole (rather than their own investors), or would act against the interests of their investors more generally. For example, there is empirical evidence in the context of equity funds that funds that can externalise the costs of fire sales are more likely to sell off non-cash assets in the market than funds that internalise these costs.
In these circumstances, prudential authorities have a role to play in the governance of liquidity management tools. To start, prudential authorities can play a role in mitigating predetermined features of liquidity management tools in extreme circumstances. For example, during the COVID-19 liquidity crunch, some regulators provided relief to asset managers regarding the maximum swing factors stipulated in the fund documentation. Absent such intervention, the cap on the swing factor would have prevented asset managers to pass on the full transaction costs to the redeeming investors. Such interventions can also limit reputational damage by imposing similar measures across similar funds. Moreover, prudential authorities should also intervene in the governance of funds when necessary for protecting the financial system as a whole. In these crisis situations, the incentives for supervisory competition amongst member states will be less strong due to enhanced public scrutiny. Moreover, they are in the best position to collect and analyse macro-level information.
Against this background, the article outlines the policy interventions necessary to improve decision-making in this area. More specifically, policy proposals in this area should focus on (1) the development of standards and guidelines for asset managers regarding the availability and use of liquidity management tools, (2) information gathering on the macro-level, and (3) supervisory coordination and convergence across jurisdictional boundaries. The 2021 Commission proposal for the review of the AIFM Directive and UCITS Directive makes some important adjustments in line with these recommendations. Addressing liquidity risk in open-ended fund is key to protect investors and maintain financial stability. The ‘right’ liquidity management tools in the ‘right’ hands can be an important step forward in improving the resilience of the fund industry against liquidity shocks.
Katrien Morbee is a Lecturer in Banking and Finance Law at Queen Mary University of London.
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