Alastair Sewell, Senior Director and regional head of Fitch Ratings' Fund and Asset Manager Group for EMEA and APAC

Fund-level liquidity risk management will be a major focus for European investment managers in 2021. The European Securities and Markets Authority (ESMA) identified the consistency and convergence of supervision of fund liquidity risk across national regulators as its key investment management objective this year.

The UK’s FCA consulted on new rules for property funds in 2020 and expects to publish final rules as soon as possible in 2021. New rules could lead to far-reaching changes for investment managers, funds and fund investors.

Fund suspensions concentrated in certain asset classes and certain markets

The importance of liquidity risk management in mutual funds was brought into sharp focus in March 2020.

Financial market stress caused valuation issues in many funds, leading to a wave of fund suspensions (i.e. when a mutual fund temporarily prevents investors from redeeming their shares in the fund for cash).

We counted well over 100 mutual fund suspensions worldwide in March 2020, the vast majority of which were domiciled in Europe. None of the affected funds were rated by Fitch.

More mutual funds suspended redemptions in a single period than at any time since the 2008 financial crisis. However, Suspended funds accounted for less than 1% of total global mutual fund assets under management (AUM). 

“Fitch counted well over 100 mutual fund suspensions worldwide in March 2020”

The suspensions were typically short, but they disadvantaged those investors who needed liquidity at the point of suspension. When rating funds, Fitch typically considers a fund suspension a negative rating event – while the suspension may ultimately protect the value of the fund, investors expect to benefit from principal preservation and liquidity availability.

Furthermore, a suspension event may accentuate conflicts of interest in the fund, both between exiting and remaining investors, and between investors and the fund provider given that fees are typically charged on AUM.

The pattern of fund suspensions reveals important differences between funds and, ultimately, the experience of investors in funds. Specifically, redemption suspensions were concentrated in:

• Funds invested in less liquid assets, notably direct open-ended real-estate funds; and,
• Funds domiciled in certain countries, such as Denmark.

Daily dealing open-ended real estate funds have a history of suspensions, and have undergone significant regulatory change already in some countries.

“When rating funds, Fitch typically considers a fund suspension a negative rating event”

In Germany, following multiple fund suspension events, regulation passed in 2013 allows funds to offer daily dealing, but with a major caveat – that any redemption requires one year’s advance notification. The FCA’s 2020 consultation proposed notice periods of up to six months for open-ended real estate funds.

Apart from real estate funds, and other funds invested in inherently illiquid assets, fund suspensions were concentrated in Denmark and Sweden. Comparable funds in other jurisdictions in Europe were less likely to suspend redemptions.

We believe this difference was principally driven by regulatory differences, rather than idiosyncratic fund features. The full range of liquidity management tools allowed under the UCITS directive has not been authorised in all countries – the only liquidity management tool available to Danish funds is the suspension of redemptions.

“Regulatory reports and anecdotal information on individual funds indicates widespread swing pricing usage in March and April 2020”

Conversely, in Luxembourg, almost all liquidity-management tools (such as swing pricing, redemption-in-kind and side pockets) have been authorised. We estimate only around 0.3% of Luxembourg-domiciled funds suspended redemptions, compared with 3.6% of Danish funds.

Swing pricing (varying a fund’s price to account for the cost of trading) stands out as a key differentiator. Public data on the extent to which swing pricing was used is not available. However, regulatory reports and anecdotal information on individual funds provided to us indicates widespread swing pricing usage in March and April 2020.

In fact, in March 2020, the Luxembourg regulator authorised funds to increase the swing factor in excess of the stated range in funds’ governing documentation as a response to the Covid-19-induced market stress.

This may have discouraged investors from pursuing redemptions that could have otherwise necessitated suspending redemptions.

Swing pricing and notice periods may complicate fund distribution

Although we cannot opine on the likelihood of any particular future regulatory path, statements of intent and the context provided by events in March 2020 point to two potential outcomes: notice periods for UK property funds and additional liquidity-management tools in certain jurisdictions.

Any such changes will require fund documentation updates and investor notifications. More complex issues may relate to net asset value processes and distribution via third-party channels.

Many funds are distributed at least partly through third-party platforms that are typically designed to accommodate daily dealing. Any move away from daily dealing, or even the addition of notice periods, may cause technological or process issues for these platforms.

“Any move away from daily dealing, or even the addition of notice periods, may cause technological or process issues”

These issues may be exacerbated if notice periods or non-daily dealing are restricted to a minority of fund types (such as real estate funds), and could limit the distribution of such funds through third-party platforms.

This could lead to reduced demand for such funds, while simultaneously increasing operational burdens if managers are forced to distribute these funds directly rather than through platforms.

Funds that operate multiple pricing points within a given day may encounter more difficulty in accommodating swing pricing than funds that price less frequently as determining, documenting and implementing a swing factor requires a certain amount of time.

Some funds may be forced to reduce the number of times they price in a day or extend the time between intra-day pricing points. This will probably affect the entire pricing value chain, involving fund administrators, custodians or trustees and the investment manager itself – possibly increasing cost and operational complexity.

“Some funds may be forced to reduce the number of times they price in a day or extend the time between intra-day pricing points”

For investors who need multiple intra-day pricing points, any reduction in the availability of pricing may reduce the attractiveness of the fund to them, potentially leading to outflows.

Conversely, if the implementation of swing pricing reduces the likelihood of the fund suspending redemptions then the fund may become more attractive to investors.

While any such regulatory changes are undecided, managers who prepare earlier may be better positioned. Along with the upcoming Sustainable Finance Disclosure requirements, we expect regulations will cause 2021 to be a busy year for European investment managers.

 

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