Road to redemption

The drumbeat of regulatory action on fund liquidity is growing louder for asset managers and the investment industry. 

The start of September has brought updates at home and on the continent. Yesterday a speech by the Bank of England’s Alex Brazier, touching on the work the central bank is now doing on open-ended funds, floated the idea of a different approach to liquidity mismatches.

DFMs will know more than most that daily dealing is crucial to the way the retail investment industry is run. So suggestions that redemption terms be lengthened are unlikely to find favour with fund investors.

But Mr Brazier’s speech also flagged a different solution: those who do wish to access money immediately “could be offered a price based on a quick-sale valuation of the fund’s assets”.

Needless to say, the implications of that shift would be significant for fund buyers. As it stands, it is just an idea - unlikely to be fleshed out any further until the BoE’s Financial Stability Report in December.

In the meantime, the industry still awaits the FCA’s own update on the rules it first proposed prior to this summer’s series of illiquidity incidents. But other regulators have already confirmed their intentions. 

The European Securities and Markets Authority has announced it will stick to the plans it first outlined in April. In short, they state that asset managers’ liquidity stress tests must now be tailored to individual funds. 

The watchdog said it believed most companies already perform such tests, but fund firms have said complying with the rules, due to arrive in September 2020, means additional costs and a struggle to source accurate data. For discretionaries who are increasingly requesting such information from providers themselves, it looks more like a step in the right direction.

Sizing up

One reason DFMs in particular are conscious of liquidity risks is because they know their favourite funds are at the upper end of the size spectrum. As we noted in May, the typical equity fund favoured by discretionaries is now more than £1bn in size. 

Admittedly, that figure is swollen by the presence of a handful of giant favourites. The problem is that these behemoths are often the most popular DFM choices of all.

The chart below illustrates that trend. In each case, we’ve provided the average size of the five most popular funds in a given sector, as judged by our fund selection database.

The pattern is consistent with those seen in our original research: it's the UK and Asian equity funds where DFMs gravitate towards the very biggest picks. And the most popular European, emerging market and Japanese equity favourites are also an order of magnitude larger than the average picks in those sectors. In most cases, it's £2bn and up.

When it comes to UK selections, the tail wags the dog somewhat. Discretionaries’ own allocations are significant enough to swell the size of these funds on their own. But the same can’t necessarily be said for other regions. 

The sense is, therefore, that wealth managers are still playing it safe with their very favourite holdings - either that or they view larger funds as less of a liquidity risk, all else being equal, than smaller peers where their positions would account for a higher proportion of total assets.

Crying wolf

Clients, like wealth managers themselves, will have realised that liquidity risk has become a tangible issue for a variety of strategies this summer. That’s not necessarily a bad thing, given the number of dogs that have not barked over the past decade.

For years they have been told that the returns of yesteryear would prove harder to come by in future. Yet that rarely proved the case: bond and equity markets have continued to rally, and domestic political and economic travails have translated into higher returns courtesy of a weaker pound.

Annual statements for 2018 will have opened some eyes to current risks, and the events of recent months will have aided, too. Clients might note their portfolios have continued to rise nicely in the meantime. But they'll also be less likely to suspect their wealth manager is crying wolf in future.