The FCA has been working with the Bank of England, at the request of the Financial Policy Committee (FPC), to assess risks posed by open-ended investment funds investing in the fixed income sector. As part of this work we have engaged with a number of large investment management firms to understand how they manage liquidity in their funds. The purpose of this update is to share good practice that we observed during the project and which is applicable across the investment fund industry.
Why managing liquidity risk is important
Investors in funds expect to be able to redeem their investments in line with the commitments made in the fund prospectus – for the vast majority of open-ended funds this means daily dealing. Good liquidity risk management that ensures redemption requests can be met in varied market conditions is a key requirement in our rules relating to the operation of open-ended funds.
Managing liquidity has become more challenging for fund managers since the financial crisis. The low interest rate environment has given rise to a widespread search for yield in fixed income securities. This has led to a greater proportion of lower-rated securities, which trade predominantly in over-the-counter (OTC) markets, and tend to offer only limited liquidity, being held in funds that offer frequent, often daily, dealing.
We observed some good practice in fund managers reviewing and updating their liquidity management in light of market conditions to ensure that their portfolios can continue to meet redemption obligations and other liabilities, and remain suitable for their specific investor base. (These and other aspects of good liquidity risk management mentioned here have been summarised in IOSCO’s Principles of Liquidity Risk Management for Collective Investment Schemes, FR03/13, March 2013).
Disclosure of liquidity risks to investors
For most funds there will be some difference between the liquidity indicated by the subscriptions and redemptions arrangements described in the fund prospectuses, and the liquidity characteristics of the underlying securities held by the fund. Good liquidity management by fund managers limits the impact of this difference to ensure that the risks to fund investors’ ability to redeem are low.
Nevertheless, as the fund investors bear the liquidity risks, it is important that they are informed about the nature and size of these risks through the fund documentation, following our existing requirements. Investors who have a good understanding of these risks are better prepared to make sound decisions during market stresses and are less likely to heighten redemption pressures by selling their fund investments when liquidity risks are accentuated by market conditions.
Good disclosure of liquidity risk to investors makes clear:
- the potential impact of low liquidity in portfolio holdings on the volatility of fund investment returns
- the ability of the fund manager to use specific tools or exceptional measures which could affect investors’ redemption rights, and an explanation of the situations in which they would be used, and
- a description of these tools and measures, and their potential impact on fund investors
Good practice on liquidity risk management and oversight
The firms we visited employ a range of liquidity management processes and tools that are tailored to the specific requirements of individual funds or strategies. During our work we identified the following good practices as contributing to strong management of liquidity risk:
- Processes to ensure that the fund dealing (subscriptions and redemptions) arrangements are appropriate for the investment strategy of the fund. Our rules for managing fund liquidity risk apply to the full lifecycle of the fund and arrangements for fund dealing should ensure that requests for redemption can be met throughout the lifecycle. An example of this good practice which we observed was a product design stage that included a review of the dealing frequency offered by prospective funds. This review withheld product approval where the fund’s investment strategy and portfolio composition were inappropriate for the dealing timetable that was proposed. Another example was the periodic review of existing products, to ensure the fund dealing timetable remained appropriate – a key factor for consideration was any material change in liquidity characteristics of securities.
- A regular assessment of liquidity demands. Liquidity demands include redemptions, collateral calls and other fund obligations. This assessment includes, but is not limited to, the development of a range of potential redemption scenarios and risks, on the basis of an analysis of the composition of fund investors; the historic pattern of net fund flows; and other factors, such as the experience of similar funds.
- An ongoing assessment of the liquidity of portfolio positions. For many portfolio holdings, for example, corporate bonds that trade infrequently, it can be difficult to obtain reliable estimates of their liquidity. In these circumstances it is good practice for firms to use a range of sources to assess the liquidity of holdings, including external data feeds and input from internal trading functions. Liquidity characteristics can vary significantly over different periods and market conditions, and portfolio liquidity assessments need to be updated accordingly.
- The use of liquidity buckets. Investment managers classify fund holdings into liquidity ‘buckets’, which are defined by the estimated time that would be needed to dispose of the holding (but they can also be defined in other ways). These buckets indicate whether the liquidity of the securities is ‘high’, ‘medium’ or ‘low’. Limits are then applied, indicating the allowed ranges of total portfolio exposure to each bucket. These limits are adjusted over time to take into account changes in market conditions.
- An independent risk function that monitors portfolio bucket exposures regularly and reports breaches to the set limits. A manager’s response to breaches can vary according to circumstances. We observed as examples of good practice the application of ‘hard’ limits, where immediate action is taken to correct the breach, and ‘soft’ limits where the position is reviewed and the limit over-ruled where appropriate and subject to the required approval process.
- Stress testing used by fund managers to assess the impact of extreme but plausible scenarios on their funds. This tool supplements other elements of the liquidity risk management process. Fund managers apply stress tests to assess the impact of a range of factors, both in isolation and in combination, on their funds and (in particular) on their ability to meet redemption requests. The results are used to inform investment decisions and, where appropriate, the level of limits on portfolio liquidity. Factors that are commonly stressed include:
(a) Volume of redemptions – funds are tested to determine the impact of the trades that would be required to meet redemptions, both in terms of timeframes and investment performance. The volume of redemptions that are tested include scenarios based on historical experience, but also other extreme, but plausible, scenarios that have not yet been experienced.
(b) Market conditions – funds are tested against market stress situations, which could severely reduce the ability of the fund to transact with other market participants.
Good practice on fund dealing
Good management of liquidity extends to how a fund manages redemptions and transaction costs related to redemptions. If managed inappropriately, this could provide an incentive for investors to redeem early, adding to the risk of a ‘run’ on their funds and further increasing problems in managing liquidity.
Good practices minimise the costs that remaining investors bear and protect them as much as possible from changes to the portfolio following redemptions. They reassure investors that the managers are protecting the interests of all fund investors. They remove any perceived investor incentives to redeem early due to fear that the last investors to redeem will be left with the illiquid portfolio holdings. In short, they protect against a ‘first mover advantage’. Communicating these fund practices and policies to investors is therefore also important.
During our work we observed the following examples of good practice:
- Portfolio adjustments following redemptions. Good liquidity management ensures that a fund’s portfolio retains the desired level of liquidity following a significant redemption request, so that remaining fund investors are not left with the illiquid assets. This can be achieved by applying a ‘vertical slice’ to the portfolio when it is faced with significant redemptions in order to leave the characteristics, including the liquidity, of the portfolio unchanged following the sales.
- An established governance process that ensures the interests of all investors are protected. In addition to monitoring ongoing redemption risk and overseeing how funds take this into account in their investment decisions, this process sets out internal guidelines on when it is appropriate to implement exceptional tools and measures in the face of large redemption demands. This includes fixing the threshold of net redemption flows which would trigger the application of such tools and measures and also assigning responsibility for a final decision to a committee, independent of the portfolio management, whose primary focus is customer protection.
Implementation of exceptional liquidity tools and measures
Swing pricing and dilution levies are two tools which are widely used by fund managers to protect investors from bearing the additional costs associated with the redemptions (and subscriptions) of other investors. Details of the full range of liquidity tools that may be implemented by funds are laid out in fund prospectuses.
These tools may include exceptional liquidity measures such as deferred redemptions and suspension of dealing. Most funds have not needed to use these tools and measures in the past. Nevertheless, we observed examples where firms have prepared thoroughly for their potential implementation. This preparation includes:
- The maintenance of a procedures manual detailing the steps required to implement each tool and measure, as well as the responsibilities of the parties involved.
- Reassurance that the operational aspects of implementing these tools and measures work in practice, including exercises to test these procedures under simulated live conditions.
Current market conditions make it particularly timely to reassess liquidity management. Our description of the good practices we have observed at leading investment management firms may help firms to improve their own liquidity management.
The FCA highlights three areas of focus for firms to evaluate when assessing their liquidity management:
- Tools, processes and underlying assumptions – these require continuous re-assessment and updating to ensure they remain suitable for market conditions.
- Operational preparedness – a high degree of reassurance that tools, particularly extraordinary measures, can be implemented smoothly when required.
- Disclosure – clear and full disclosure to fund investors on liquidity risks and the tools available to the fund to manage those risks, such as swing pricing, deferred redemption and suspension.