Liquidity, or the ease of buying and selling an investment, has been at the centre of one of the big stories of recent months. Liquidity, or rather the lack-of, has contributed to the downfall of a number of former star fund managers.
We look at how these situations came about and how at Architas we strive to avoid the pitfalls of investing in illiquid assets.
Capturing the illiquidity premium
Perhaps the greatest challenge for investors in recent years has been the quest for yield against the backdrop of central banks’ supportive action. Massive bond-buying programmes, also known as QE, have pulled bond prices higher, pushing bond yields lower. This has tempted fund managers who promise investors a certain level of yield to boost income by ‘capturing the illiquidity premium’. In simple terms, this means investing in assets which offer a higher yield because they trade in less liquid corners of the market. After all, a higher yield compensates for the risk of owning any particular asset. And that risk can be the lack of liquidity. Problems arise when fund managers are unable to meet client redemptions because they have too much invested in illiquid assets.
Fall from grace
Recent high profile examples are instructive, not least because their punishment was so dramatic. Consider a fund invested in large-cap stocks, a fairly trouble-free part of the market. However, the fund is also permitted a ‘trash bucket’, investing in unquoted stocks, up to the 10% maximum allowed under the UCITS structure. After a period of underperformance, the fund is hit by redemptions.
Holdings at the more liquid end of the portfolio are sold to meet the redemptions, meaning these illiquid stocks grow bigger and bigger as a percentage of the fund. Finally, the 10% limit is breached and the fund is closed to further redemptions, trapping investors for a period of time.
Identifying potential liquidity traps
So how best to side-step these traps? For the average equity fund manager, the process is a fairly simple one. By looking at the historical average trading volumes for a stock, a fund manager can judge if there is sufficient liquidity to exit a position if the stock becomes stressed. For a fund buyer, the puzzle is rather more tricky, as you are a step-removed from the assets.
How to escape the illiquidity trap
At Architas we monitor a set of liquidity metrics before investment. For listed investments, such as closed-end investment trusts, we can analyse historic trading volumes to take a view on its liquidity. Investment trust managers are generally not obliged to meet investor redemptions, making it a structure that is well-suited to the ownership of illiquid assets.
For open-ended funds, which are subject to regular subscriptions and redemptions, the risk is that the advertised fund liquidity may not be consistent with the liquidity of the underlying assets.
When a fund is invested in listed securities we conduct look-through analysis to understand the liquidity of the underlying positions. This is a lengthy process that requires access to holdings and a system to analyse them that might not be feasible for all fund buyers.
We then calculate how big the fund is within its investment universe. If it is too dominant there will be fewer counterparties to provide it liquidity. Another consideration is how much of the fund we own and the impact this could have on our ability to redeem.
When a fund owns unlisted assets, we evaluate the general nature of the assets, whether they are commodities or property assets, for instance, to judge where the investment sits on a scale between highly liquid and highly illiquid. We could use property as an example. It is immediately apparent to anyone who has ever tried to sell property that the concept of daily liquidity does not sit well with this asset class.
We also constantly monitor the underlying holdings of a fund, to gauge where liquidity and other risks might arise. This look-through analysis requires a good relationship with a fund manager, as these details are not typically found on a factsheet.
Diversification is key
Liquidity management is a key concern when managing the Diversified Real Assets Fund (DRA) as it is naturally drawn to less-liquid, physical assets.
We are careful to be diversified across asset classes, underlying funds and to access assets through the most appropriate structures. After a strong run of performance in 2019, DRA is currently at the more defensive end of its history.
Despite recent events, disclosure of funds’ liquidity generally remains poor so, with these liquidity risks in mind, the approach that Architas would favour is simply to remain diversified.
A rule change?
Where does regulation go from here? After a sequence of high profile, liquidity events it is likely that stricter limits will be applied. However, imposing tighter rules on existing funds risks triggering a wave of redemptions as investors look to exit before new rules come into force.
The availability of a ‘10% trash bucket’ within the UCITS fund structure has proven to be problematic. Its use makes a fund at risk of suspending if it can’t meet redemptions and incentivises investors to be early redeemers, leaving loyal investors trapped with illiquid assets in a gated fund.
The hunt for yield has only intensified over the last decade, which could continue to draw investors towards less liquid areas of the markets. For Architas, this makes continuous engagement with the fund managers we invest in, including close attention to their portfolio changes, ever more vital.
Solomon Nevins, Senior Investment Manager, Architas