Is a liquidity rating system for asset managers a good idea? Is daily liquidity for investors necessary, when some such as pension funds invest for 10, 20, perhaps 30 years? Should gates or side-pockets, more traditionally used by hedge funds, be introduced?
As regulators voice their concerns about the liquidity risks of asset managers, the industry itself has privately started to question the framework underpinning long-term investment. One senior risk professional floats the idea of a liquidity scale, rating the liquidity of funds' underlying investments; he says it could avert an upheaval in asset managers' business models. Others question whether European regulators should look again at Ucits funds' requirements to provide liquidity, given their nervousness around this subject. Most Ucits funds offer daily liquidity, although a few offer weekly or bi-monthly redemptions.
The chief risk officer (CRO) at a major European asset manager urges bodies such as the European Securities and Markets Authority (Esma) and the European Systemic Risk Board (ESRB) to think again about the industry's ‘sacred cow' of providing daily liquidity, and consider more options of limiting withdrawals in illiquid times, which he thinks the industry is afraid to discuss with regulators.
"Regulators and bodies like the ESRB are scratching their heads. They don't feel comfortable about liquidity… and they're trying to get transparency and understand the dynamics," he says. "I'm not sure whether the regulators will get us to a considerably better place than where we are now. There is an opportunity: let's see whether we're able to [take] it."
Risk.net spoke to eight senior professionals at asset managers and data providers to find out how that could be done.
The ESRB is probing the investment industry in a broader study, due to be published in a few months, into the risks of a fall in liquidity. The study aims to find out whether open-ended funds have sufficient liquidity to meet redemptions in stressed conditions.
The CRO thinks current industry talks with Esma will produce piecemeal regulations on liquidity that "feel plausible to a non-expert", such as transparency and reporting requirements similar to those proposed by the Securities and Exchange Commission (SEC). The SEC has proposed open-ended funds hold a minimum buffer of liquid assets and limit illiquid assets to 15% of their portfolios, but asset managers are dissenting over definitions of liquidity.
Most of the people Risk.net spoke to saw no need for big changes to European regulations, as fund managers are already required to have systems to manage liquidity. However some see change as a political necessity.
To prevent an overhaul of regulation, a CRO at a UK insurer's asset management arm suggests a liquidity rating system, similar to Morningstar's fund performance ratings. "The question is if you [can] disclose to the client what kind of liquidity will be maintained in a fund, on the basis that you can say this is a one-rated fund or a five-rated fund, so they know automatically," he says.
The fund's liquidity score could be based on the liquidity of asset classes in which it was invested, with monthly or quarterly changes. Alternatively, analytics for investors could produce a real-time liquidity thermometer that goes up or down, based on changing market conditions. Such ratings, calculated by a data provider, would enable investors to compare funds' liquidity.
"In a way, I think it's not so difficult because, in some way in the prospectus, you do declare what you are going to invest in. It is more of a solution than saying we should all keep tons of cash around," he says.
The CRO at a major European asset manager sees the appeal of a rating system: "I could in principle see this as being positive for the handling of liquidity risk as it would increase transparency to the investor." It might send the right messages to regulators, he adds, that transparency is better than over-regulation.
The best regulation is more and more disclosure. You have to allow markets to find the right price
Piotr Chmielowski, Fulcrum Asset Management
He thinks a more granular ongoing liquidity metric is unappealing. "I would see this as potentially tricky; it might in the worst scenario provide more confusion than transparency," he says, questioning whether it would be precise enough or even comparable across funds.
The head of public affairs at another asset manager, who requested anonymity, worries that any liquidity rating would oversimplify matters.
"It may be misleading, especially because people tend to over-rely on the rating," he says. "Ratings in credit are okay because you do not change your views in credit so often. Ratings in liquidity will move much more frequently if there is objective data."
He doubts regulators would consider better liquidity metrics an appropriate solution and reckons it would not delay the desire to regulate. "Objective criteria are already in place in risk management of funds… The real answer is education. Investors have to understand when they buy a fund, that they are exposed to market risks," he says.
Piotr Chmielowski, CRO of Fulcrum Asset Management in London, agrees: "The best regulation is more and more disclosure. You have to allow markets to find the right price."
He sees problems in providing an objective measure of the liquidity of a fund's holdings. "Liquidity can't be forecast accurately. The drivers of liquidity are more complex than anything," he says, pointing to factors such as market direction and volatility, both of which are hard to predict. Liquidity can simply vanish, making life harder for any metric provider.
Data provider Markit measures the liquidity of credit default swaps (CDSs), loans and corporate and sovereign bonds, but its indexes may be seen as being as subjective as any other liquidity metric. The provider's composite index captures the number of dealers, number of price sources and bid-ask spreads. For bonds, it accounts for maturity and whether a benchmark yield curve exists. For CDSs, it also includes volumes, number of price points and index membership.
A spokesman for Markit admits there is no truly objective liquidity measure: "Liquidity has an interesting dynamic. The same bond could have a different liquidity profile, depending on the manager. Are they able to find buyers to a seller within the organisation somehow? Do you they have access to lines of credit? How [good] are their traders? How are their relationships with the sell-side?… What type of tools do they have to hedge?"
He says a hedge fund with an ability to hedge its portfolio can manage its liquidity better than a long-only mutual fund. "[This] is another reason why the same bond could potentially behave differently, depending on the type of vehicle it sits in."
An extra difficulty with developing liquidity ratings is that funds do not provide enough disclosure for data providers. "If the SEC would just concentrate on improving portfolio disclosure and standardisation, you would see more people in the private sector coming up with ways to assess liquidity," says Scott Cooley, Chicago-based director of policy research at data provider Morningstar.
"The SEC acknowledged in its [September 2015] proposal that two managers might classify their holdings differently, which is a problem because it would make it tough for external users to make comparisons across portfolios. In some conversations with fund managers, it did seem like people would tend to be very conservative in their reporting because of fears about litigation," he says. Fund managers might prefer, for example, to say an asset can be liquidated in five days rather than three, he thinks.
If the SEC would just concentrate on improving portfolio disclosure and standardisation, you would see more people in the private sector coming up with ways to assess liquidity
Scott Cooley, Morningstar
"In some ways the rules around portfolio reporting are pretty out-of-date," he says. The SEC's current list of derivative categories – forwards, futures, options, swaptions, swaps, warrants and other – leaves major derivatives under the definition of "other". Within this framework, it is unclear if a CDS would be considered an option or a swap, Morningstar wrote in its reply to a consultation by the SEC.
"[We] support the SEC's efforts to collect granular position information, which will allow the SEC and third parties such as Morningstar to use consistent calculation methodologies across funds," the company wrote.
Morningstar is also working with investment associations in France, Germany and the UK to develop more coherent reporting for over-the-counter instruments. Ben Alpert, senior research engineer at Morningstar in Chicago, says: "Measuring liquidity isn't standardised and [many] bond markets aren't electronic so you don't know what the liquidity is."
Several of the asset managers Risk.net spoke to see the need to move away from the daily liquidity offered by most Ucits funds. "If markets really turn illiquid, a couple of days don't get you that far," says the CRO of a major European asset manager.
"In the conversations between the industry and the regulator, it's a no-go area, because no-one wants to talk about it: neither the regulator nor the industry, because it's a scary scenario. It raises the question whether the regulatory rules about daily liquidity in funds are best to protect the investor's interests."
He questions whether more flexibility might be required in offering daily redemptions. Otherwise, faced with heavy redemptions coupled with the obligation to treat clients fairly, an asset manager might be forced to close a fund. With restrictions such as gates, investors would still get their money back in a stressed scenario but a little slower. Alternatively, side-pockets could be used to separate liquid from illiquid assets in a portfolio, so investors would be entitled to a share of the side-pocket only when the underlying assets had been sold.
Nonetheless he says limiting daily liquidity is taboo. "Marketing-wise, you're at a disadvantage; hence no-one really dares step into this area because it's much harder to sell, even to a pension fund… Daily liquidity should not necessarily be so high on their radar screen but factually it is."
Sean Collins, director of industry research at ICI Global, an asset management industry group in Washington DC, says he would strongly oppose any change to daily liquidity of mutual funds, which he sees as a "fundamental feature" of US ‘40 Act funds.
It's not clear getting rid of daily liquidity would solve investors' problems, he says, as demand for open-ended mutual funds is always high. "With hedge funds, they have [longer-than-daily] intervals and the redemptions simply pile up around those redemption dates," he says.
He reminds dissenters that daily liquidity was introduced in 1940 "not as a service to investors but as a discipline on funds": to make it difficult for fund managers to bilk investors or hold overly illiquid assets.
Niels Holch, founder of the Coalition of Mutual Fund Investors in Washington DC, says limits on daily liquidity "would face great resistance from individual investors in the US" with about 95 million US citizens invested in mutual funds.
"I think we will always have a mutual fund with daily liquidity that's offered to mutual investors. I don't think that will change," he says.
The week on Risk.net, December 2–8, 2017Receive this by email