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Changing the liquidity goal posts

Fund liquidity terms come under scrutiny yet investors demand access to illiquid assets

Recent incidents have sparked further regulatory and investor discussion about fund liquidity. In June 2019, the Woodford Equity Income Fund gated investors after it failed to meet redemption requests when it was unable to liquidate some of its illiquid assets. The fund was later suspended, and subsequently the decision was taken to close the fund. More recently, the investment management firm announced it was closing down.

Shortly after the June 2019 gating at Woodford, H20 Asset Management experienced outflows of EUR 8 billion when several media publications reported that six of its funds were exposed to more than EUR 1.4 billion of illiquid bonds.1 In both circumstances, the funds offered daily liquidity and were regulated under UCITS, a mutual fund wrapper available to retail investors.

Key insights

  • Mutual fund liquidity terms are likely to incur growing regulatory interest from UK and EU regulators
  • Proposed new fund structures aimed at retail clients could be one way for the industry to give investors access to more illiquid assets, with clearer redemption provisions
  • All fund managers need to ensure that portfolio holdings correlate to their funds’ liquidity terms

Further re-regulation of UCITS cannot be ruled out

Since these events, regulators in the United Kingdom have made public their concerns about perceived deficiencies in the UCITS regime. The Bank of England’s Financial Policy Committee and the Financial Conduct Authority (FCA) have both stated they are scrutinizing how funds can feasibly offer daily redemptions despite investing in assets that may take weeks or months to sell.2

The FCA adopted an even stronger position, suggesting that UCITS’ prescriptive requirements created an environment for liquidity mismatches to emerge. Specifically, the FCA noted that the rule limiting UCITS from holding no more than 10 percent of their capital in unlisted assets was flawed3 and could be reviewed post-Brexit.4

The European Union (EU) is also reviewing liquidity risk management practices for UCITS fund managers, and alternative investment fund managers (AIFMs). ESMA released its final guidance on investment fund liquidity stress testing in September 2019. This guidance, which will become compulsory from September 2020, requires UCITS and AIFMs to perform liquidity stress tests and notify local regulators of any material risks.5

ESMA has also said that depositaries must check that fund managers have documented procedures in place for their liquidity stress testing programs.6

New fund structures and new rules focus on investor protection

Industry groups have been looking to better protect investors since the suspension of seven property management funds after the Brexit vote in 2016.7 While not directly related to those suspensions, the Investment Association (IA) announced in June 2019 that the Long-Term Asset Fund (LTAF) structure it has been developing, which is a modified version of the Non-UCITS Retail Scheme Structure (NURS), would have appropriate liquidity provisions and would not offer daily liquidity to investors.8 Exact details about the nature and liquidity terms of this proposed vehicle are expected to be released later this year.

The FCA recently released rules that will apply to certain types of open-ended funds that invest in inherently illiquid assets, such as property

In the meantime, the FCA recently released rules that will apply to certain types of open-ended funds that invest in inherently illiquid assets, such as property. “We want people to continue to be able to invest in illiquid assets, such as real estate, through open-ended funds but it is important that they are appropriately protected,” commented Christopher Woolard, Executive Director of Strategy & Competition at the FCA.9

These rules include a number of key features and provisions:

1. The rules introduce a new fund category, ‘funds investing in inherently illiquid assets’ (FIIA) and those funds will be subject to increased disclosure of how liquidity is managed, risk warnings in financial promotions, enhanced depositary oversight and a requirement for liquidity risk contingency plans (already considered to be best practice). These provisions will not apply to funds that match the dealing frequency of their shares to the liquidity of assets.

2. NURS investing in inherently illiquid assets will be required to suspend dealing if it is determined that there is a material uncertainly regarding the value of more than 20 percent of the fund’s assets.10

The FCA acknowledged that, “Liquidity issues can extend to other open-ended funds, including UCITS, where they have holdings of less liquid assets even including investment in listed equities if there is not a liquid market in those equities.”

Liquid alternatives?

Liquid alternatives are not a new concept. The United States (US) permits alternative fund strategies to be sold to retail investors through mutual fund wrappers regulated under the Investment Company Act of 1940 (’40 Act). Such products do, however, face regulatory restrictions.

Securities and Exchange Commission rules require large funds to limit exposure to illiquid assets to no more than 15 percent of their holdings, and also subjects them to stringent liquidity risk reporting.11 Liquid alternatives have not, however, enjoyed much success in the US, with sales falling 90 percent from 2013 to 2017 owing to lower performance.12

Canada has also developed a liquid alternatives regime. Amendments to National Instrument 81-102—which came into force in January 2019—now allow liquid alternatives to be distributed to retail investors.13 Similar to the rules underpinning traditional mutual funds, illiquid assets cannot make up more than 10 percent of the net asset value of a liquid alternative fund.

The retailization of alternative investment products, in the context of recent liquidity events, presents an interesting industry dynamic. While most liquid alternatives do not replicate esoteric hedge fund strategies, industry experts have cautioned that firms could face asset-liability mismatches if they stray from the rules.14

With regulators poised to scrutinize retail mutual funds’ liquidity practices, it is essential that managers keenly focus on liquidity levels and only give investors the right to make daily redemptions if the fund’s underlying assets allow for that degree of flexibility.

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