Mutual fund liquidity: A true oasis, or merely a mirage?
We are now 10 years into a period of economic expansion, yet there are cracks appearing in the growth foundation that many investors are pondering. The market has become more sensitive to changes in the prospects for risk assets. If a meaningful deterioration in fundamentals occurs, it is very possible that we will face liquidity challenges in a variety of spaces. Mutual funds are seen as key vehicles of liquidity, and most investors assume they will always be able to extract their money from them when they want. Is that guaranteed?
While mutual funds are designed to provide daily liquidity, investors are right to consider that this liquidity is not guaranteed. This post is intended to outline potential risks that can exist and to help investors better understand risks that they might face.
Blurred lines: Liquid vs. private markets
Investors traditionally divide markets into liquid and private. They expect liquid markets to be tradeable on demand and to provide fair and accurate pricing on a regular basis. Private markets, on the other hand, are typically acknowledged to be illiquid. Most investors here recognize that their capital will be inaccessible for a period of time, and that they’ll need to rely on certain events to provide liquidity windows.
However, the reality between the two markets is significantly more nuanced than this, for three main reasons:
- The line between liquid and illiquid is blurry. While exchanges provide a constant source of pricing for securities, that doesn’t mean that meaningful volumes can be transacted in their entirety. Sometimes, for instance, the volume is so thin that trades happen very sporadically, or not at all. Some private investments issued in a club-style format can also be sold, even if that was not the original expectation.
- Liquidity in instruments is constantly changing, which is what drives market pricing. Sometimes, this liquidity can change so dramatically that the volume of sales overwhelms potential bidders if some particularly surprising event manifests. What may have been easy to trade in one environment can become impossible in another.
- Determining liquidity is a judgment call rather than a science. High-liquidity instruments would appear to have large volumes trading regularly to a variety of constituents. However, determining what large volumes, trading regularly and variety of constituents actually means is not straightforward. Rather, it requires a judgment call from an investor, and is typically influenced by how much they need to trade, what they can foresee as risks to the market and how others might behave. In effect, this is a very qualitative decision.
While the expectation for investment vehicles like mutual funds is to continuously provide daily liquidity, regulators have implicitly acknowledged these nuances in the bond market. Mutual funds in many jurisdictions, including UCITS (Undertakings for the Collective Investment in Transferable Securities) vehicles in the European Union and 40 Act vehicles in the U.S., have allowances for illiquid securities. Each provides powers for mutual funds to gate redemptions or further levy some form of transaction cost.
It is the case that most mutual funds have committees to help establish prices of securities when it’s difficult to observe such prices in the market, or when instrument prices are not reacting to information that would otherwise trigger a reaction. Investors should be aware that such features exist to aid in the continuing function of mutual funds under periods of market stress, and that liquidity air pockets are necessary. This does indicate, however, that maintaining daily liquidity is not always possible.
It’s important for investors to investigate liquidity and be comfortable understanding the dynamics of the asset classes they invest in. Data transparency is very difficult for assets off exchanges, but we believe it’s worth trying to explore these areas as well. All else being equal, there are some things to look for when considering the magnitude of illiquidity in an investment:
Exchange-traded or OTC (over the counter)
Exchange trading gives a point of central clearing for demand in a security and usually has a certain level of transparency around the trading activity. This allows a better understanding of the underlying liquidity, but does not necessarily imply that such instruments would be more liquid. Many fixed income instruments are dealt with OTC. Transparency and price discovery can be more difficult in the over-the-counter market, as there is no central comprehensive point of liquidity. However, there are many bonds with abundant liquidity, such as U.S. Treasuries and large corporate bond issuers.
- The size of the market for the asset in question is a good indicator of liquidity
Previous larger-size issuance of securities indicates that there’s likely a deep pool of interested parties, as they’ve clearly supported large issuers before. The U.S. Treasury grows the size of its outstanding debt at a rate of roughly $1 trillion each year1, which is being sold, indicating very solid liquidity. Contrast that with an AIM-listed stock in the UK, which may have a market cap of £50 million or less. One would not expect to see much, if any, meaningful daily trading in such an instrument.
- The concentration of different market participants
Some asset classes are primarily driven by a smaller group of market constituents who have similar economic needs. The fewer the market constituents, the larger the probability of a market event impacting liquidity, as the economic needs of one constituency can change en masse.
- The number of counterparties available
Another indicator of liquidity for a security comes in the number of counterparties that comprise markets in specific segments of the market.
- Frequency of trading and volume of trading
More frequent trading and higher volume is a sign of deeper liquidity. Securities that exhibit trading during periods of market stress are also likely to have better liquidity.
The importance of assessing the liquidity profile
Beyond each asset class’ inherent liquidity consideration, we believe one should also consider the liquidity profile of the vehicle they are investing in. In other words, what are the terms of liquidity being offered in the vehicle versus the potential demands for liquidity? Some key points to consider include:
- Liquidity mismatches
Most funds have a mix of highly liquid and less liquid investments. Understanding this mix can clarify the risks of a fund running into a liquidity challenge. In the rare case that there’s a liquidity mismatch that comes under pressure, the asset manager has options to continue to provide liquidity. For instance, they could mark the asset at a lower price using internal processes, which would shrink the size of that asset relative to the rest of the portfolio. This obviously provides negative performance, but can keep a vehicle liquid.
- Size of fund and large unitholders
Larger funds are likely to have significant diversification of unitholders, which typically means less chance of having a shock draw on a fund’s liquidity. For example, consider that you’re the investor in a fund whose largest unitholder own 95% of the units. Liquidity could be demanded from that investor and potentially challenge the fund’s ability to meet the redemption.
- Dealing terms and restrictions
Understand the dealing terms in the fund’s documentation. Many asset managers in Europe, for example, can apply a dilution levy or swinging price in the cash of large subscriptions or redemptions. This is designed to protect existing unitholders from having to subsidize large trades. This feature is not prevalent in North America.
- Manager’s approach to handling illiquid holdings while in redemptions
We believe that it is important to understand a manager’s approach to portfolio construction in periods of redemption. We believe this means that managers should seek to sell illiquid holdings, even if doing so hurts performance, as it will ultimately keep the portfolio strategy intact for the remaining unitholders.
The bottom line
Mutual funds are designed to provide daily liquidity—and investors have come to expect this. While the clear majority provide just that, it’s important to bear in mind that not all mutual funds are the same. This is why we believe it’s critical for investors to understand the vehicle and asset class they’re invested in, in order to gauge the possibility of facing a potential illiquidity problem.Typically, the most liquid asset classes offer the least potential return and alpha, which leads investors to seek higher-return asset classes and products—which generally have less liquidity. It can be difficult to balance this desire with maintaining perfect liquidity. Above all else, investors should be aware that prices may become significantly impacted by liquidity, and that no product is immune from the potential of liquidity challenges.