The $55tn industry has emerged scared and shrunken but largely intact
Siobhan Riding
© AFP via Getty Images
In the third week of March, when the dizzying market swings caused by the coronavirus emergency were at their peak, the eyes of the investment world were fixed on the $3.8tn US money market fund sector.
An investor exodus from US prime institutional funds left portfolio managers scrambling to sell assets, threatening their liquidity profiles and paving the way for fund suspensions.
Yet the investment industry’s worst fear — that the liquidity crunch would spiral into a widespread run on funds as when the Reserve Primary fund “broke the buck” in 2008 — did not materialise due in part to interventions by the US Federal Reserve.
While it is an extreme example, the disaster averted for money market funds mirrors the picture for the wider $55tn asset management industry, which has emerged from the recent market turmoil scared and shrunken but largely intact.
Though many funds have activated emergency liquidity management tools, few have been unable to fulfil redemption requests immediately or been forced to suspend trading. Just 80 funds out of the near-35,000 sold in Europe were suspended in March, despite investment groups being hit by record outflows and precipitous drops in asset prices, according to Fitch Ratings.
“Given that this was the worst crash since 1929, it’s extraordinary that the majority of open-ended funds are still operating,” says Julie Patterson, head of asset management, regulatory change at KPMG.
The lack of widespread problems suggests that the regulations governing investment funds
are working as they should do, contradicting longstanding warnings from central banks to the Financial Stability Board that more stringent rules are needed to prevent fund liquidity mismatches.
“The next time the FSB or European Central Bank call for asset managers to be subject to macroprudential supervision because they pose a risk to the financial system, we will be pointing to this crisis and arguing that our industry has proved its resilience so far,” says Tanguy van de Werve, director-general of the European Fund and Asset Management Association.
However, many believe the fund industry’s real test is still to come. Certain sections of the market, notably fixed income funds, came under severe strain in March. Large drops in the price of corporate debt and difficulties valuing some corporate bonds had made it hard for managers to produce a reliable measure of how much money their clients had lost and fulfil redemption requests.
These stresses could have spilled over into much bigger problems if central banks and governments had not intervened to shore up markets. According to calculations by rating agency Fitch, central banks have stumped up a total of $93.8bn to support investment funds since the health crisis began.
“It is reassuring that there were not widespread runs on traditional mutual funds. There were large redemptions and the system didn’t break,” says Tobias Adrian, director of the monetary and capital markets department at the IMF. “But the resilience among investment funds was conditional on massive central bank intervention on a scale we have never seen.”
This was evidenced further last month when India’s central bank launched a Rs500bn ($6.6bn) liquidity infusion for funds in an effort to head off contagion stemming from Franklin Templeton’s suspension of six local bond funds following an investor run.
As the Covid-19 crisis drags on and more companies collapse, it is likely that funds will sustain further hits to their portfolios, triggering a new wave of investor redemptions. The IMF is concerned about how bond fund managers will cope when they run down their cash buffers, which it estimates at 7 per cent on average, although some funds have less.
Adding to the IMF’s fears are the fact that paper-thin interest rates have pushed some fund managers into riskier, less liquid assets over the past decade as they have aggressively pursued yield.
“I wouldn’t exclude that a number of funds that are investing in weaker credit may go bust during this crisis,” says Mr Adrian. “Certain funds exposed to bonds that are defaulting will see redemptions, and they will run out of liquidity eventually.”
Frank Hespeler, senior financial sector expert at the IMF, says recent price dislocations and the “substantive level of liquidity stress” observed in investment funds point to the presence of a “weak tail of vulnerable funds [which] could grow quite quickly in volume depending on redemptions”.
One way that funds can keep these problems at bay is by deploying liquidity risk management tools. These range from deferring redemption requests, tapping credit lines or “swinging” the price of the fund to pass on the costs associated with high outflows to redeeming investors.
Ms Patterson says that regulators’ authorisation of a broader range of liquidity management tools since the 2008 financial crisis has stood fund managers in good stead. Swing pricing, for example, which has been activated by managers including Fidelity, Amundi, Goldman Sachs Asset Management and BlackRock over the past two months, according to regulatory disclosures, is a relatively recent innovation.
These tools can encourage investors to stay in funds and give fund managers time to reposition their portfolios, enabling them to avoid a fire sale of assets. However, they cannot change the liquidity profile of their funds.
In addition, adoption of liquidity risk management tools varies from manager to manager.
Monique Melis, managing director at regulatory consultancy Duff & Phelps, argues that some managers are “still reticent” to use mechanisms such as redemption gates or notice periods, fearing negative reaction from clients. “No investor is enthusiastic about provisions which delay them recovering their money,” she says.
Another lever fund managers have is liquidity stress tests, which help them integrate liquidity concerns into portfolio construction and make sure they have enough liquid assets to meet a surge in redemption requests.
But Alastair Sewell, head of funds and asset manager ratings for Emea and Apac at Fitch, says there is “a question around how severe a stress fund managers are incorporating into their liquidity risk management and whether [the recent crisis] constitutes a new realm of stress that the existing practices are inadequate to deal with”.
New EU rules on liquidity stress testing are set to be imposed on European investment funds later this year. However, these were formulated before the crisis and do not provide for the unusual market conditions experienced during this period. Olivier Carré, partner at PwC Luxembourg, expects regulators to mandate more detailed stress tests in future based on specific scenarios.
Questions around asset managers’ resilience to liquidity risk also centre on funds’ structure and whether strategies that allow investors to redeem their money on a daily basis should be exposed to less liquid assets.
This debate is already high on regulators’ agendas following the blow-up of UK stockpicker Neil Woodford’s investment business last year, as well as the repeated suspension of several popular UK property funds.
The stress experienced by products such as high-yield bond funds in March provides fresh ammunition to policymakers seeking to ensure funds’ redemption terms are aligned with the liquidity of their underlying assets.
The IMF wants policymakers to force bond fund managers to comply with eligibility criteria based on credit quality and liquidity metrics before adding assets to their portfolios. It also recommends that asset managers are required to match the redemption period of their funds to the liquidity profile of their portfolios better to mitigate the potential for fire sales.
“The issue of fund liquidity was already a regulatory priority and the recent market turmoil has only served to underscore it,” says Sean Tuffy, head of market and regulatory intelligence at Citigroup. “Hard questions will be asked about the need for daily liquidity for all fund types.”
Before this overhaul can happen, however, policymakers will want to see how well investment funds withstand the rest of the crisis. The IMF’s Mr Adrian predicts there will be a “weeding out of badly run mutual funds from well-run mutual funds”.
What is less clear, however, is whether vulnerable funds will go bust in an orderly fashion or whether they trigger a run on the wider fund industry, creating contagion effects across the global financial system. The answer to this question will determine the direction of asset management regulation for years to come.
*Several funds subsequently reopened or were liquidated, although the majority remain suspended
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