Liquidity In Open Ended Investment Funds-What’s Next?

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Kevin Tomlin

Liquidity in open-ended investment funds, particularly UK authorised funds, remained a hot topic during 2023 which looked likely to continue in 2024 and possibly beyond. With liquidity, investors have the right to redeem their holding in an investment fund at will, typically daily. Therefore, the fund manager must have sufficient liquid assets to meet the redemption demand. That is a simple principle but managing it is not always simple.

There are already extensive rules and guidance about the importance of good liquidity management in authorised funds. Therefore fund failures as a result of poor liquidity are few and far between, so why should any more be done?

A little history

For many years liquidity in authorised investment funds was not discussed. In the UK most authorised funds invested in highly liquid securities (often in many FTSE stocks), and investors could redeem at will. That changed when it was proposed that authorised open ended property funds should be allowed in the UK. The fact that this caused a debate about liquidity in such funds was hardly surprising, given that investments in bricks and mortar have very different trading arrangements to those in listed securities. Apart from property funds, concerns about liquidity have now moved onto traditional funds. This was more alarming as those types of funds invest exclusively in liquid assets, at least they should. Therefore, there should typically be no problem when investors want to redeem their holdings.

The property fund dilemma

The traditional view in the UK was that investors in funds designed for sale to retail investors should have the right to redeem at all times. Hence, a fund must be sufficiently liquid to enable that but how would that be possible if the fund, by the nature of its investments, lacked liquidity. The Financial Services Authority struggled with this dilemma. Ultimately, authorised property funds were permitted, but only on the basis that they held sufficient cash or near cash. Subsequently, this was changed to allow fund managers to decide how much cash or other liquid assets needed to be held. Whilst all the authorised property funds survived the 2008 market crash, other events since then (such as the Brexit vote) have led to their suspension, sometimes on more than one occasion, and some have closed.

Some commentators have looked on this as a failure of the open-ended property fund model. Others have taken the view that suspension of a fund was an appropriate tool to manage a lack of liquidity and that investors should be aware that suspension may occur, and ultimately, closure may be in an investor’s best interests.

Liquidity management in traditional funds

More recently there have been concerns about liquidity management in more traditional funds such as bond and equity funds. Some of these reflected markets and some reflected investment behaviour. In many respects, problems in such traditional funds were more alarming as they were widely understood almost to guarantee redemption at will. They all fall under the European banner of the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, which was primarily designed for retail investment. Innovation in investment strategies in UCITS funds have put a strain on two underlying principles of the Directive: 1) that they were based on the principle of risk spreading; and 2) investors were able to redeem their holdings on demand.

That strain would occur if a) there was a relatively high level of less liquid stock in a fund; b) redemption demand was high and c) redemptions were met by continually selling assets that were easy to dispose of. The remaining investors would then be left in a fund that had increasingly illiquid stock. In that sense, they would be disadvantaged. This was contrary to the manager’s duty to treat all investors fairly by not favouring the interests of one set of investors (the leavers) over another (the remainers). It would be the remainers that suffer disproportionately if the fund was suspended and closed. Clearly fund regulators are concerned about this, particularly when investors have lost money, as in the case of the, well publicised, Woodford fund.

Such experiences have led the FCA to review fund managers’ liquidity policies, procedures and practices. The review culminated in an FCA letter last summer to CEOs of authorised fund managers, it highlighted good and poor practice, and required firms to review their liquidity management arrangements. Fund managers that have not done this would be well advised to do so now.

Up and coming

More regulatory activity on liquidity will inevitably follow on from this. As a slightly early Christmas present the Financial Stability Board (FSB) and the International Securities Organisation (IOSCO) published their final recommendations in December 2023 on liquidity management, following consultation last year.

Some of IOSCO’s recommendations repeat and build upon what they said in 2018. The FSB’s recommendations are more likely to lead fund regulators to review their rules and guidance in an attempt to strengthen liquidity management. In the interim it would be worthwhile if fund managers studied the recommendations and made any necessary changes to their policies and practices.

Thus, whilst there was already much in the public domain that should assist managers, there will clearly be more to do this year and beyond until regulators are satisfied that robust liquidity arrangements are in place throughout the industry.