Of Relevance to:
Managers of open-ended investment funds
Liquidity Management in Funds
The FCA has published comments – there is no stand-alone paper as such – on ‘Liquidity management for investment firms: good practice’.
The comments arise from work undertaken in conjunction with the Bank of England to assess risks posed by open-ended investment funds investing in the fixed income sector. The work undertaken included engagement with a number of large investment management firms to understand how they manage liquidity risk in their funds. The publication of the comments reflects the FCA’s desire to “share good practice that we observed during the project and which is applicable across the investment fund industry”.
Management of liquidity risk is, of course, an essential component in meeting investors’ expectations when redeeming their investments – it is recognised that the concept of ‘liquidity’ captures both the subscriptions and redemptions profile of the fund in question as well as the liquidity of the underlying investments within the fund. The latter element can pose particular problems in a low interest rate environment where the search for yield may lead to a greater proportion of lower-rated securities which are often associated with limited liquidity.
Good practice points include:
- Ensuring that subscriptions and redemptions arrangements are appropriate for the investment strategy. Examples quoted include periodic reviews of existing products to ensure that the dealing timetable remained appropriate to any material change in the liquidity characteristics of the underlying securities.
- Regular assessment of liquidity demands. Such an assessment should as a minimum include the development of a range of potential redemption scenarios and risks based upon factors such as the historic pattern of net fund flows and the composition of fund investors.
- Ongoing assessment of the liquidity of portfolio positions. This will acknowledge that liquidity characteristics can vary significantly over different periods and market conditions.
- The use of liquidity buckets. Scheme holdings could be defined in terms of the estimated time that would be needed to dispose of the holding with limits then applied indicating the allowed ranges of total portfolio exposure to each ‘bucket’.
- Independent risk function to monitor such buckets. This would report breaches of the agreed ranges mentioned above to the relevant manager. Such limits can be either fixed so that immediate action is taken to correct the situation or, alternatively, the limits can be ‘soft’ so that each breach is reviewed and, where appropriate (and subject to a suitable approval process), the limit can be over-ruled.
- Stress testing. Factors commonly used include volume of redemptions and market stress situations.
- Portfolio adjustments following redemptions. Ensuring that the fund’s liquidity as a whole is unaffected following major redemptions so that the remaining investors are not left with the illiquid assets.
The article also references IOSCO’s ‘Principles of Liquidity Risk Management for Collective Investment Schemes’ of March 2013.
When considering the good practice points outlined in the FCA article, managers of funds will no doubt bear in mind that UCITS Management Companies are already required to consider liquidity risk as part of their overall risk management policy (see Article 38 of Implementing Directive 2010/43) with a similar obligation for AIFMs (see e.g. Article 46 of Delegated Regulation 231/2013).
Although there are no specific requirements imposed upon investment managers in the article, it does conclude with “current market conditions make it particularly timely to reassess liquidity management. Our description of the good practices we have observed at leading investment management firms may help firms to improve their own liquidity management”. Managers of open-ended funds would be well advised to read the FCA article in full; assess whether any of the ‘good practice’ points are absent from their own processes and procedures; and to consider implementing them to ensure that their own firms follow ‘best practice’.