Investors need to be made aware of the liquidity risks posed by any funds they invest in, the Financial Conduct Authority has said.
The regulator has been working with the Bank of England to assess the risks posed by open-ended investment funds investing in the fixed income sector.
The watchdog’s work has been prompted by the increasing difficulty fund managers have finding yield in fixed income securities, which has led to a greater proportion of lower-rated securities that trade predominantly in over-the-counter markets and tend to offer only limited liquidity.
In an update on this work, published today (29 February), the FCA said disclosure to investors in one of three areas the industry should focus on.
It said: “As the fund investors bear the liquidity risks, it is important that they are informed about the nature and size of these risks through the fund documentation, following our existing requirements.
“Investors who have a good understanding of these risks are better prepared to make sound decisions during market stresses and are less likely to heighten redemption pressures by selling their fund investments when liquidity risks are accentuated by market conditions.”
The FCA said fund managers should make clear the potential impact of low liquidity on the volatility of returns and describe any specific tools or exceptional measures which the fund manager has available to them and which could affect investors.
As part of its work the FCA has visited a number of large investment management firms to understand how they manage liquidity risk.
In its update the City watchdog also shared examples of what it considered to be good practice in managing liquidity risk.
These include stress tests by managers to assess the impact of extreme but plausible scenarios on their funds, the classification of fund holdings into “buckets” depending on their liquidity, and portfolio adjustments following redemptions.
The FCA said: “Current market conditions make it particularly timely to reassess liquidity management.
“Our description of the good practices we have observed at leading investment management firms may help firms to improve their own liquidity management.”