Liquidity in financial markets
Posted by Liz Rees in Latest insights category on 09 Aug 19
A suspension of dealing in the widely held Woodford Equity Income fund, and difficulties relating to illiquid assets in two bond funds (GAM and H2O), has drawn attention to the issue of liquidity. The extensive press coverage may prompt investors to question whether other funds could experience similar problems.
What do we mean by liquidity?
The IA (Investment Association) defines liquidity as how easy it is it is to buy and sell investments such as shares, bonds or property. This includes the time taken to transact and the impact on the price. The EU directive on UCITS (a common regulatory framework which applies to most funds traded in Europe) classes illiquid securities as those not listed or traded on a regulated market.
Most trades on the London Stock Exchange are carried out via its own computer based system, SETS, which matches buyers and sellers electronically throughout the day. Larger stocks trade more frequently and in greater volumes than smaller ones.
At the other end of the spectrum, direct property funds wanting to sell commercial properties will have to appoint an agent and negotiate a price, which means the transaction can take much longer to complete. As a result, several of these funds had to be gated when there was a surge in redemption requests after the EU referendum.
As well as the type of investments held, liquidity is affected by market conditions. In rising markets, this is less of an issue. Even with less liquid assets, there are opportunities as companies issue new equity on a regular basis. However, when markets are falling and sell orders increase, liquidity can dwindle until prices fall enough to attract buyers.
How do fund managers handle liquidity?
Most of the time, there are both buyers and sellers so units can be created and cancelled without having to sell significant amounts of the underlying assets. Moreover, many funds hold cash reserves of up to 5%.
Regulations are in place to ensure that fund managers act in the best interests of investors. Firstly, funds are not permitted to invest in a combination of assets that could ‘compromise overall liquidity’ and secondly, no more than 10% of assets held in UCITS can be in assets not traded on a liquid market. If illiquid assets are held, the strategy must be published in offer documents, for example the KIID.
Liquidity must be monitored by a fund’s Authorised Corporate Director (ACD) or, in the case of a Unit Trust scheme, by the scheme manager, and reviewed regularly. Fund managers also carry out liquidity analysis at least monthly or quarterly. This involves stress testing holdings to ascertain whether there would be sufficient liquidity in a range of scenarios, such as unexpectedly high withdrawals or major political events.
When problems arise, FCA rules allow funds either: one extra day to make cash available; redemption at fixed points only (up to every 6 months) or, on rare occasions, suspension of dealing. The latter is only resorted to if unexpectedly high withdrawals means it would not be possible to receive a fair value for the assets. It is intended to protect those who stay invested and the FCA only takes this action if it considers it is in all investor’s best interests.
It is also important to keep an eye on the size of a fund, as it may reach a point where it becomes difficult to establish desired positions. This has occurred with Smaller Companies funds which may take the decision to ‘soft close’ (to new investors) in an attempt to keep the fund at a manageable size.
The Woodford Equity Income Fund
In this somewhat unique case, there was a snowball effect; a period of poor performance from a ‘star manager’ led to negative reviews and an escalation in outflows. Some investors had been unaware that a significant proportion of holdings were in smaller and unquoted stocks, often representing large stakes in the companies owned.
In the first instance, more marketable stocks were sold but this led to the illiquid part of the portfolio breaching the 10% regulatory limit. The final straw came when a large investor (Kent County Council) placed a sell order for £250m. The suspension is intended to allow reasonable time for the fund to be rebalanced.
What about bonds?
Unlike shares, most bonds are not traded on exchanges but over the counter (OTC), using an intermediary such as a bank. They are usually traded in large minimum sizes amongst institutional investors.
Bonds range from government issues to the debt of fairly small companies, and increased regulation on capital requirements have affected secondary market liquidity in some areas. The most liquid bonds are those with a fixed coupon and the principal paid on maturity. Short duration bonds (with less time to maturity and lower sensitivity to interest rates changes) are also more liquid.
Many funds have low turnover and hold bonds to maturity but those seeking higher yields (over 5%) from more complex structures may face liquidity constraints. However, most have a range of exposures across various credit ratings, maturities and issuers. The current environment of low yields, low volatility and low defaults has been benign for liquidity, apart from some very high risk issues. Purchases of bonds by central banks under quantitative easing programmes have also helped.
Are investment trusts a better home for illiquid assets?
The problem with holding illiquid assets in open ended funds, such as OEICs and unit trusts, is that they have intended long-term holding periods and are not easy to realise on demand. Investment trusts, on the other hand, are closed end funds, listed on a stock exchange. Sales are executed through the market and the fund manager does not have to sell any assets. Trusts are popular for investing in property, infrastructure, biotechnology and private equity.
However, their structure does not make them safer investments. The share price is dictated by market demand and therefore can move to significant discounts, or indeed premiums, to underlying asset value.
Liquidity is an investment risk
All investments carry varying degrees of risk, be it financial, currency, default, inflation, interest rate or liquidity. Investors buy illiquid assets in the hope of superior returns and despite the bad publicity arising from the Woodford situation, private equity has produced impressive returns over the long-term. Indeed, the IA has proposed the introduction of a long-term asset fund, designed to facilitate investment in illiquid assets, which would only allow investors to sell at certain intervals.
It is important not to confuse liquidity of individual assets with the liquidity effect of market sentiment. A global shock, such as the financial crisis, can make it difficult to sell most assets. Market falls at times of stress can be dramatic but bounce-backs can also be swift so panic selling may be detrimental.
Always remember that investing is a long term commitment and immediate income requirements should be kept in cash or near cash. A bond, or indeed an equity income fund, can meet a need for regular income but be aware that a quest for high yields also comes with higher risk.
: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.