Mixed messages on fund liquidity risk
Take two exchange-traded funds (ETFs), both on sale to retail investors, both investing in dollar-denominated high yield bonds. The funds are run by the same asset management firm, both track an index from the same benchmark provider and both promise their authorised participants (APs) the ability to create and redeem fund units daily on the basis of the underlying net asset value (NAV).
APs are the entities that transact in wholesale lots with an ETF fund issuer, an interaction that dictates how the fund is priced in the secondary market, where most of us buy and sell it.
Yet in one prospectus we read that the ability of investors to exit the fund may be curtailed in a number of circumstances. The ability of APs to redeem their fund units, says the prospectus, may be suspended if any of the principal underlying markets are closed or if the fund’s directors decide it’s difficult to determine the NAV.
More broadly, redemptions can be halted if the directors decide a suspension of dealing is in the interests of the fund, its shareholders or the investment company (an “umbrella” structure under which tens of ETFs are issued).
And even if none of these things occur, the fund may limit redemptions to 10% of the fund’s assets a day, meaning that large withdrawals may be scaled down and that those heading for the exits may have to wait.
Under any of these circumstances you could expect secondary market trading in the ETF to come to an effective halt.
In the other prospectus—remember, for a fund sold by the same firm, tracking an index in exactly the same asset class—there’s no mention of a possible suspension of redemptions.
All we read is that “if particular investments are difficult to purchase or sell, this can reduce the fund’s returns because the fund may be unable to transact at advantageous times or prices” and that, if it’s difficult to obtain reliable quotations for securities held by the fund, its manager may use a so-called “fair value” approximation of the securities’ worth in order to calculate the NAV.
Why the difference in language? The first fund operates in Europe and in compliance with the region’s UCITS rules. The second is a US ETF, operating according to the 1940 Investment Company Act, the governing regulation for US mutual funds.
A central principle of the 1940 Act is that investors should be able to redeem their fund units on demand. Unlike in Europe, where local regulators accept the possibility that redemptions may be suspended or “gated”, the US mutual fund rules dictate that fund inflows and outflows should continue even when the liquidity of underlying markets is compromised. There are very narrow exceptions to this principle, mainly relating to the closure of local (US) equity markets.
Does this difference in regional approaches matter?
In its March 2013 principles for the management of liquidity risk in collective investment schemes, IOSCO, the international coordinating body for securities regulators, accepted that liquidity crises in funds are less likely to cause systemic confidence problems than when the same occurs in the banking sector. Investors know they can lose money when buying a fund, or they should do.
But IOSCO’s principles are very high-level and non-prescriptive, no doubt as a result of the transatlantic differences in fund frameworks. In 2012 the regulatory body skirted around the fundamental gap in mutual fund rules by saying that the suspension of redemptions by a mutual fund may be justified only if permitted by (local) law.
IOSCO—whose principles are non-binding—has advised fund managers that they should not promise more frequent liquidity to investors than is appropriate for the underlying asset class and that liquidity risk and a fund’s liquidity risk management process should be effectively disclosed to prospective investors.
Again, this is subject to very wide interpretation in practice. Mutual funds promising daily redemptions (and, in the case of ETFs, instantaneous dealing), now invest on a large scale in a variety of asset classes that have been prone to liquidity crises in the past, from high yield bonds, to emerging markets equity and debt and even senior bank loans.
BlackRock, the asset manager responsible for the two ETFs I mentioned earlier (Europe-listed SHYU and US-listed HYG), has recently called for globally consistent best practices for fund structures, liquidity risk management and investor disclosure.
This is a hot topic, with those charged with ensuring the stability of the financial system now taking a much closer look at whether mutual fund run risk could cause wider contagion. IOSCO and the G-20 Financial Stability Board are due to issue a new consultation on systemically important non-bank financial institutions by the end of the month.
If a fund issuer gates redemptions in one jurisdiction, could there be a run from its funds elsewhere? I don’t know. But while local rules continue to differ so markedly, it’s hard to see how US investors are getting the same message on fund liquidity risk as those in Europe.