Author: Minyue Wang, CFA
Market developments in 2019 increased investors’ and regulators’ attention to mutual funds’ liquidity risks, and this focus will continue in 2020. Open-end funds would benefit from more robust, MMF-like frameworks, says Minyue Wang, CFA, associate director in Fitch Ratings’ Fund and Asset Manager Group in London
While money market funds (MMFs) are only a subset of open-end funds, and one that focuses on a much lower risk/return profile than open-end funds broadly, the liquidity risk management frameworks MMFs employ are instructive in their considerations of asset liquidity, investor composition and historical outflows.
The Woodford and M&G gating incidents in June and December 2019, respectively, highlight the structural weakness of open-ended funds that have material mismatches between the redemption terms offered to investors and the liquidity (or lack thereof) of underlying assets. They also show the potential for problems at one entity to spread quickly to related entities and other parts of the financial system.
The Central Bank of Ireland published an industry letter in August 2019 to the chairs of fund management companies, emphasizing the importance of effective liquidity management, as well as the responsibility boards, individual directors and relevant designated persons have with respect to funds’ liquidity risk management. Furthermore, the latest financial stability report published by Bank of England in December 2019 indicated that the mismatch between redemption terms and the liquidity of some funds’ assets can potentially become a systematic risk.
Liquidity Risk Management in MMFs:
MMFs, alternatively referred to as liquidity funds by some market participants, seek to provide liquidity on demand and to preserve principal. Most, if not all, of the European short-term MMFs offer daily redemptions, with a settlement of T0 or T1.
European MMF regulation requires “low volatility net asset value” and “public-debt constant net asset value” fund variants to comply with minimum thresholds of 10% and 30% for overnight and weekly liquidity, respectively. In practice, most Fitch-rated funds manage substantially higher levels of liquidity, with around 30% overnight liquidity and 42% weekly liquidity (including natural liquidity and eligible assets) on average as of end-October 2019.
This excess liquidity above minimum regulatory standards reflects funds’ assessment of their investor bases. Since enhanced MMF regulation came into force in March 2019, average liquidity levels across rated funds have been broadly stable, but the range of liquidity levels has expanded upwards, with the maximum level of liquidity in funds meaningfully higher than before the enhanced regulation came into force. This effect has been most pronounced in funds with more volatile investor flows.
Fitch also notes that funds tailor their liquidity levels to maximum historical outflows. For example, as of end-September 2019, all sampled funds had overnight liquidity greater than their maximum daily outflow over the prior six months. Nevertheless, the difference between liquidity levels and maximum outflows within a fund can be material when comparing across funds.
The MMF regulation also requires funds to conduct liquidity stress tests. One of the prescribed scenarios requires funds to compare weekly liquidity levels with the amount of the funds owned by the two largest investors. This stress test aims to simulate sudden, material redemption pressure on a fund.
We found that 82% of Fitch-rated funds had sufficient weekly liquidity to cover the redemption of their top two investors as of end-October 2019. For the 18% with weekly liquidity levels below the sum of their top two investors, the top two investors were typically either internal money or omnibus accounts consisting of multiple underlying investors, mitigating redemption risk. The point being, that size, as well as type, matters when considering investor exposures.
In summary, MMFs represent one of the most conservative open-end fund structures, consistent with the high ratings often assigned to such vehicles. Open-end fund vehicles more broadly exhibit higher risk/return profiles, but the fact that they offer periodic redemptions makes robust liquidity risk management frameworks paramount. Open-end funds would benefit from more robust, MMF-like frameworks that consider the liquidity of their investments, the nature of their investors and historical redemption experience.
Minyue Wang, CFA, associate director in Fitch Ratings’ Fund and Asset Manager Group in London