MSCI has published a report looking to establish if the suspension of redemptions at Woodford Equity Income Fund (WEIF) is representative of liquidity problems across the industry.
The index provider and ratings agency believes that the problems WEIF faced highlight the importance of a fund’s liquidity profile, and establish it as a key component of managing risk.
The report also argues that misaligned liquidity can be a risk for both institutional investors as potential liquidity mismatch can prevent clients from withdrawing capital upon request, while a suspension of withdrawals will harm a fund manager’s reputation.
Incidents of funds banning redemptions should be familiar to any investors with holdings in UK commercial property funds. When the UK voted to leave the EU in the summer of 2016, property funds faced a barrage of redemption requests and large players in this sector had to suspend their funds, including M&G, Columbia Threadneedle and Aberdeen Asset Management. The firms needed to wait to see what impact the vote had on their funds' NAVs before allowing redemptions to resume.
Laszlo Hollo - Vice President in MSCI’s Risk Management and Liquidity Core Research team, authored the report titled, “Is there another Woodford waiting to happen?". In its analysis, MSCI has researched over 400 UCITS funds, assessing whether European UCITS funds hold an excess of illiquid securities.
The report analyses the liquidity of a sample of European funds with similar characteristics to Woodford’s. It scrutinised UCITS funds with assets under management greater than €1 billion that primarily invest in equities.
Most of the funds MSCI covered were highly liquid, however the report concludes that a minority with liquidity issues could create mismatches between liquidity profiles and potential redemption requests. Even though the vast majority of the analysed UCITS funds seemed sufficiently liquid, a handful had relatively large exposure to liquidity risk. Its analysis suggests a handful of large equity UCITS funds had the potential to suffer the same problems affecting WEIF.
Mr Hollo also explored the liquidity rules of the U.S. Securities and Exchange Commission (SEC) when looking at potential solutions for the issues. Across the Atlantic, regulators prevent open-end mutual funds from holding more than 15 percent of their investments in illiquid assets, with the aim of reducing the likelihood of redemption suspensions. The SEC require fund providers to rank their products in one of four ways relating to liquidity; highly, moderately, less and illiquid.
Among the 15 least liquid UCITS funds in its analysis, seven breached the Security Exchange Comission's 15 percent illiquid-holding limit, while approximately one percent had less than 50 percent of its holdings in the highly liquid category. It should be noted that there are approximately three-times as many UCITS products as US-based mutual funds
However, the report also not.es that more regulation is not necessarily the only way of placing emphasis on liquidity. Although European regulation do not set limits on holdings, funds complying with the rules on the continent must allow redemptions at least twice a month, with many UCITS funds permit withdrawals on any day – a practice known as daily dealing. This may create an incentive for a UCITS fund to hold sufficiently liquid investments to ensure alignment with daily dealing.
Mr Hollo cites Andrew Bailey, chief executive officer of the U.K. Financial Conduct Authority, who argues that the impracticality of illiquid assets could serve as a deterrent.
He said: “It is not sensible to provide for daily dealing and redemption in open-ended funds that hold a large exposure to illiquid assets, including those that while listed are not regularly traded.”3
Charles Gubert, in a report published by the New City Initiative think tank titled: “Are Revisions To UCITS Necessary?” has also commented on WEIF’s situation and its future consequences.
He is much more sceptical of daily dealing and it’s capabilities to create a culture of consistent liquidity.
In response to WEIF’s gating, he argues that it might be prudent to “curtail the ability of UCITS managers to offer daily dealing funds moving to monthly or even quarterly dealing.”
Mr Gubert believes this would “extend the time horizons for investors and managers alike, helping the industry to deliver more patient capital”.
In addition, he also does not believe changing UCITs rules or altering regulations so that they are more comparable to US regulators such as the Securities Exchange Commission would be effective.
He said: “It has also been suggested that the UCITS rules could be changed to limit investments in unlisted or illiquid securities, but given liquidity can fluctuate hugely, and always reduces in points of crisis (when it is most needed), this does not necessarily solve the problem. Strategies that flirt with illiquidity should operate as closed-ended vehicles, where there is always a price available for clients to get out, albeit it may be at a steep discount (so the customer makes a choice about how important it is to have liquidity).”
He acknowledges that the success of UCITS is based primarily on it being “a trusted brand”, and that “recent events at the Equity Income Fund – which itself was a UCITS – could threaten this long-held perception.”
“While no laws were technically violated, the entire episode should force regulators to consider whether structural changes need to be made to the UCITS regime,” he noted.
Commenting on a potential solution, he suggested that all choices had drawbacks, recognising that retail investors could be affected by efforts to manage risk.
He concluded: “A more sensible option would be to ensure there are tighter governance checks on UCITS to ensure risk and investment mandates are not being flouted. Alternatively, EU regulators could change the redemption terms for UCITS, permitting only the most liquid strategies to offer daily liquidity, but of course that would severely restrict the opportunity set for retail investors.”
