Risk Management: Clear and ever present
Alastair Sewell outlines how the insidious nature of liquidity risk affects investment strategies
Liquidity risk is a key issue but also one which divides market opinion. For those investors encumbered by liquidity risk constraints, returns are likely to be depressed as they implement portfolio construction and risk management strategies to mitigate this risk. Conversely, for investors who can hold to maturity or invest with extended horizons it may be an opportunity to acquire illiquidity premia. Even in these cases, though, it is still important to recognise that the longest of horizons might not be immune to liquidity risk.
In March, the UK’s Financial Conduct Authority (FCA), stated “there is no evidence that liquidity outcomes have deteriorated in the market… If anything, the market appears to have become more liquid in recent years”.
In contrast to the FCA’s views, most investors at a Fitch event in May on liquidity risk said that liquidity has become more fragmented, which is not necessarily apparent in broad market data sets.
Across the universe of fund managers and funds we rate, we have seen an increased focus on liquidity risk. Fund managers readily admit being forced to work harder to achieve liquidity.
The issue of liquidity risk is particularly acute in fixed-income mutual funds. Daily dealing is the lifeblood of the industry. Fitch estimates that over 90% of pan-European UCITS bond funds offer daily dealing, with little differentiation by asset class. For example, funds in less liquid asset classes such as high-yield and emerging markets offered daily dealing 96% and 98% of the time, respectively. Funds may be challenged to meet this market convention in certain less liquid asset classes such as emerging market corporates in periods of stress.
For investors in separately managed mandates liquidity risk may seem a distant concern. But it has a pernicious influence on mandate investment strategy and can present a direct risk at mandate termination.
Liquidity risk exacerbates market volatility. We counted 15 volatility spikes (of more than 10% weekly volatility) in 2015 – almost twice as many as the eight we counted in 2008, in the midst of the global financial crisis. This increase in volatility has coincided with broad-based market concerns over fixed-income liquidity.
In a buy-and-hold mandate, an investor can weather such volatility well. However, for revolving mandates, liquidity risk is affecting investment strategy in three key ways.
First, there is an ever greater focus on credit fundamentals, as investment ideas are constrained by liquidity. Investment managers increasingly assume they will be holding to maturity, as they may well be unable to sell on demand. As a consequence, investment managers have to accept the resource cost of maintaining or strengthening their benches of investment professionals.
Second, there is a countervailing force at work in trading desks. On the one hand, technology is causing equity-dealing desks to shrink; on the other, fixed-income investment managers place an ever greater premium on trading capabilities.
Traders have shifted from providing execution only, to becoming more embedded in the investment process. This means active information-sharing on liquidity conditions, suggesting trade ideas and identifying trading strategies to allow the acquisition – or disposal – of one or more securities without having too great a price influence – for example, through using external trading platforms or internal crossing networks.
Price influence is an important topic; investment managers and traders routinely tell us that they cannot transact at ‘screen price’, although many say they can transact without too much price slippage.
Third, there is an ever greater emphasis on managing liquidity risk. Our asset manager and fund-quality ratings address a manager’s ability to meet its investment objectives. In doing so, we include an analysis of the manager’s liquidity management capabilities and processes. However, the binary nature of liquidity risk can leave even the strongest liquidity risk management framework adrift when the wells run dry. Preparedness for facing a liquidity crisis will be a differentiating factor from a rating perspective.
Basic liquidity risk-measurement frameworks focus on market observables – dealer inventories, traded volumes, bid-offer spreads. In many cases, such data is used to develop liquidity scores – some of which are also available from market infrastructure and data providers. An important issue with traded volume data is that they miss failed trades – arguably a more informative indicator of liquidity conditions. Another concern is how trades are recognised: if the IBM 2024 bond traded tomorrow but the 2023 does not, does that make the 2023 bond illiquid?
More sophisticated liquidity risk management techniques take these building blocks and add technical factors such as fund flows, issuance or redemption behaviour. Some investment managers use these data to inform liquidity stress tests, which can be sophisticated.
This all filters through to portfolio construction where we see liquidity risk-based considerations becoming important factors. Specifically, this can mean smaller position sizes in both absolute and relative terms (that is, more diversified and granular portfolios), the maintenance of higher cash balances either to meet redemptions (if needed) or to deploy opportunistically into liquidity-driven market sell-offs and greater use of derivatives (such as credit default swaps) to create synthetic, liquid exposures.
While these measures can help mitigate liquidity risk, they can also mean material changes in fund risk profiles – we see both increased counterparty risk as investment managers use more derivatives, and more ‘bar-belling’ – that is, offsetting lower quality and derivative exposures with large cash and government bond holdings.
Mandates may be vulnerable to liquidity risk at, or in the run-up to, mandate termination. This risk is acute if the mandate’s end-state is cash for redeployment. If, however, the mandate terminates with delivery of securities and the investor intends to hold them to maturity the liquidity risk evaporates.
To achieve a cash position at the end of a mandate’s term, the investment manager can either rely on secondary market sales or natural maturities. The former clearly incurs liquidity risk; the latter potentially too. In this scenario the manager – or investor – faces the issue of what to do with the cash received.
There are, broadly speaking, two solutions. One is to make short-term investments in strategies close to that of the mandate, typically mutual funds or exchange traded funds (ETFs), or to invest in high-quality money market securities or funds.
Mutual funds face inherent liquidity risk. There is a structural mismatch between the liquidity some offer and the liquidity of the asset classes in which they invest. It is also apparent that ETFs have seen strong inflows and significant trading volumes. How they would perform under a severe liquidity stress scenario remains relatively untested.
Liquidity stress penetrates even the money markets, the bout of Bund illiquidity in April 2015 being a case in point. Reforms coming into effect in the US from October 2016 will mean that money market funds could potentially gate if their proportion of weekly maturing securities falls below a threshold of 30%. Our money market fund ratings specifically consider liquidity risk.
Alastair Sewell is head of fund and asset manager ratings, EMEA & Asia-Pacific at Fitch Ratings