Fund liquidity is one of the many items in the Financial Conduct Authority's (FCA) intray.
It’s just published its findings into what’s known as a "liquidity management multi-firm review". This sounds dry and technical but it has far-reaching implications.
What’s the Latest?
In its latest review, the regulator found most firms were found to have adequate liquidity measures, but these are inconsistently applied across the industry. And as often happens when the FCA investigates an area of the market, there’s always "more to be done". A minority of companies came up short. Even the most compliant firms showed gaps.
"Some firms demonstrated very high standards in liquidity management. However, we found a wide disparity among firms in the quality of compliance with regulatory standards and depth of liquidity risk management expertise," FCA director Camille Blackburn said.
"Most firms fell short in some aspects of their framework. A minority of firms had inadequate frameworks to manage liquidity risk effectively."
But this isn’t just a recent issue – the FCA wrote to asset managers in 2019 to ask them about how they manage liquidity risks.
What Have Firms Done Wrong?
Many firms had the potential to perform well, the FCA says, with the right building blocks and tools in place. But "these lacked coherence", it said, and were not always followed through on day-to-day basis. The regulator also found different approaches to "stress testing", an exercise common in the banking industry where firms are required to predict certain negative scenarios.
The regulator also said liquidity management was not sufficiently embedded in many firms' governance structures, particularly in relation to how firms react in times of stress.
Firms also drew fire for the way they approached measuring liquidity; the worst approaches involved using cash and the most liquid assets first to meet redemption requests.
Why Does Liquidity Matter for Fund Investors?
Investing in the stock market is inherently risky on a capital level; the price you sell at may be lower than you paid for it. In theory that’s the tradeoff you make when you forfeit the safety and liquidity of cash and chase higher returns.
What’s different is you also risk money not being immediately available when you want it.
In every global liquidity crisis of the last few years, including the crypto collapses of 2022, it becomes clear that everyday investors had a different view of what liquidity means to those in charge of their money. Often this comes to the fore in times of market stress when investors want to withdraw money, effectively turning risk assets into cash.
"Investors should be able to redeem at an accurate price that reflects the value of their investment, ensuring fairness for both remaining and redeeming investors in the fund. Management of liquidity is central to that, particularly during periods of market or redemption stress," Blackburn said on 6 July.
As such, liquidity management needs to balance the need of those who sell and those who stay – so sellers don't impact "holders" when they exit their holdings.
Who Does This Affect?
Potentially a lot of people. Many UK investors buy open-ended funds.
Morningstar rates hundreds of them in the UK and 125 have a Morningstar Medalist Rating of Gold. Open-ended funds have a liquidity dilemma built into their structure – they have to sell units to meet redemption requests. Usually this isn’t an issue – but when there’s a "rush to the exits" it can become difficult to manage, especially if the assets themselves are hard to sell (if the fund owns shares in early-stage companies or direct assets like buildings).
Open-ended funds have a different dynamic to large investment trusts and FTSE 100 companies, whose shares are openly traded on the stock market. In theory these are more liquid than funds because pricing is real time and there are often ready buyers available when people want to sell (even when prices are falling).
Are There Examples of Funds Failing to Manage Risk?
There are plenty from the last few years.
As the Woodford debacle and the Covid-19 pandemic have shown, investors in funds are often faced with obstacles when a crisis strikes; they want to be able to exit their position at a "fair" price but are often unable to. Woodford Equity Income was suspended in June 2019 as it was unable to meet a wave of selling requests. The winding down process was controversial and investors are still waiting to be fully compensated.
During the Covid-19 crisis, many open-ended property funds "gated" to stop a flood of redemption requests. Some of the funds formerly managed by Crispin Odey have gated to stem outflows.
This is a common method of managing liquidity risk; although it’s not always popular with investors, it can be a way of withstanding selling pressure until an immediate crisis passes.
But though gating sometimes protects the assets of existing investors, it can damage confidence in asset classes too.
Are There Any Loose Ends?
Yes. In the case of these property funds, they’ve now re-opened, but investors will be aware when buying these funds that gating is always a possibility – in times of crisis they can’t sell buildings or offices to meet redemptions. The FCA has been looking into this "liquidity mismatch" for years. (There's also an issue connected to valuations and pricing.)
We wrote about this in 2020 as the regulator proposed making investors give six-month notice before withdrawing.
This debate has moved on as the industry is now focused on long-term asset funds (LTAFs), which the current government is backing. As AJ Bell’s investment director Laith Khalaf says, the regulator and Treasury may be pulling in different directions.
"At the same time the FCA is telling asset managers to manage liquidity risk, the regulator is also in the process of opening up long-term asset funds investing in highly illiquid assets to retail investors," he says.
"The initial impetus for LTAFs came from none other than Rishi Sunak, in his former role as chancellor. The not-so-subtle goal is to tap up the large amount of money sat in pension funds for investment in UK infrastructure and start-ups."
What Happens Next?
As the regulator points out, the review was conducted before new consumer duty rules came into effect this month. But it stresses that this review is still key to achieving what it calls "improved consumer outcomes" – a key tenet of the consumer duty.
The "Dear CEO" letter from the FCA that accompanied the findings made it clear what asset managers need to do to improve their liquidity management. But it stopped short of imposing tougher requirements on them, as the FCA says current regulatory requirements should be enough.
Global regulators are also looking at this issue, to it seems likely the UK will "align" with international standards on this.
