Fund liquidity: what it is and why it matters

Fund liquidity is back in the spotlight following a warning by the Financial Conduct Authority. Kyle Caldwell explains what exactly fund liquidity is, and why this can lead to fund suspensions.

Fund liquidity concerns have resurfaced following a warning by the City watchdog that some asset management firms have “inadequate frameworks to manage liquidity risk”.

The Financial Conduct Authority (FCA) told asset managers in its multi-year review to increase their focus on liquidity risk. The regulator said that allowing investors to withdraw funds should be “in line with their expectations and at an accurate price that reflects its value”.

The FCA said firms typically had governance and organisational arrangements in place to meet large one-off redemptions, but lacked sufficient arrangements to oversee market-wide redemptions that could have a significant impact on a fund. 

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Camille Blackburn, director of wholesale buy-side at the FCA, said: “We have seen examples in the market where liquidity risk has crystallised and the impact this can have on investors. 

“This review should serve as a warning to all asset managers that they need to get this right. We expect boards to discuss our findings and assure themselves that their firms are not among the minority with serious gaps in managing liquidity risk.

“It’s vital the outliers take quick action. They risk regulatory intervention if they don’t take this opportunity to address weaknesses.” 

But what is fund liquidity, and how concerned should investors be? Our guide below explains all.

What is fund liquidity?

Most funds should not have any problems when investors wish to withdraw their money. 

Liquidity is basically a fund’s access to liquid assets, for example, cash, or assets that can be quickly and easily converted to cash without losing value.

Most funds are highly diversified and hold a wide spread of investments listed on a stock market, so they are unlikely to have liquidity problems.

If and when there’s a large withdrawal request – either from an institutional investor with a large stake, or if many investors want to sell at the same time – a fund will first exhaust its cash weighting (typically around 5% for an equity fund), and then sell down the most liquid holdings.

The FCA’s multi-firm review, however, warned that relying on such a practice in liquidity stress tests can give a “false sense of security” and may skew the portfolio’s subsequent composition. Fund management firms should have other measures in place, such as the ability to sell a proportionate ‘slice’ of the portfolio’s assets. In non-jargon language, this means potentially trimming every asset in the portfolio to fund the redemption. Doing so helps maintain asset allocation and portfolio liquidity, which is a fairer outcome for the remaining investors.

The suspension of Russia-linked funds in February 2022 was both unique and unsurprising given that the Moscow Stock Exchange has closed. Fund managers are unable to sell the investments held in the fund to return money to investors. Some funds have closed or changed their mandate, while others remain suspended.

• Russia crisis sparks fund suspensions
• The funds, investment trusts and ETFs with exposure to Russia

Why does liquidity matter?

For an investor, liquidity matters because you can end up not being able to access your money if fund suspensions are put in place. In addition, the value of the underlying investments in the fund can also fall as funds scramble to meet redemption requests.

Investors in commercial property funds are particularly vulnerable. Such funds have put suspensions in place on several occasions, including following Covid-19, the Brexit vote and during the financial crisis. 

In normal market conditions, it is not a problem for investors to withdraw money on a daily basis, as a portion of the portfolio remains in cash, typically 10% to 20% for commercial property funds.

However, during times of heavy selling, it is a different story, as the cash buffer is depleted. This makes it difficult for open-ended commercial property funds to meet withdrawals on a day-to-day basis.

This is because the sale of shops, offices and factories held in portfolios are not quickly or easily arranged, particularly in times of market uncertainty, and it is therefore very difficult to raise money quickly.

Such a scenario can negatively impact investors who remain in the fund, as the manager is forced to sell investments for less than they are worth to gather enough money to repay investors who have hit the sell button.

Private companies are also inherently illiquid, due to not being listed on the stock market. The 10% limit on unlisted holdings for funds sounds like a small percentage, but the suspension and subsequent closure of the LF Woodford Equity Income fund shows that illiquid holdings can prove very problematic when investors rush to the exit. 

If in order to return cash to investors a fund sells its most liquid holdings the unlisted portion of the fund can increase in percentage terms relative to the rest of the portfolio.  

Unlike funds, investment trusts do not have this liquidity problem. Under the trust structure, a fixed number of shares are issued, raising a fixed amount of money for the manager to invest in a portfolio of assets. Those shares are traded on a stock exchange and their price fluctuates according to demand and supply.

Crucially, the fund manager does not have to sell or buy shares depending on whether they are attracting or losing investors. This makes trusts a more suitable vehicle for illiquid assets and, arguably, allows the fund manager to take more of a long-term view while running the portfolio.

However, while the upshot with funds, such as commercial property, is that fund suspensions can be put in place, panic-selling is a comparable problem for investment trusts. Commercial property investment trust managers are not forced to sell property to redeem investors, but the market can take a dim view of the outlook and force share prices down, causing discounts to widen.