With expected continued volatility and the implementation of further far-reaching financial regulations in the US and Europe, 2016 is likely to see liquidity remain on centre stage.
New rules proposed by the US SEC are set to increase pressure on asset managers to improve transparency around the liquidity of their holdings. Under the rules, which began a 90-day consultation period in September 2015, managers of US-domiciled funds would be required to classify the number of days it would take to convert holdings into cash. Funds would also be required to establish a minimum amount of assets that could be converted into cash within three days without materially affecting the price of those assets prior to sale.
The UK and Europe are not untouched by similar initiatives. The UK’s Financial Conduct Authority has been gathering information from UK-based asset managers on how they manage liquidity in investment funds in both normal and stressed conditions. In addition, by 2017 the UK along with other European Union member states will have to adhere to the forthcoming Mifid II Directive, which contains rules aimed at increasing transparency of bond markets for investors.
The increased involvement of regulators follows heightened anxiety through much of 2015 over liquidity in the asset management industry, particularly in the fixed income market. The fear is that in periods of market stress a “rush for the exits” by investors would force funds to sell assets at a loss to meet redemptions, resulting in a liquidity crunch.
James Gereghty, Jr., managing director and head of distressed investing at Siguler Guff & Company1, notes that, as the occurrence of episodic volatility has increased globally, so too has the reliance of capital on liquidity.
“Despite significant reductions in private capital leverage, lending activity and the velocity of capital remains historically high, which implies high market liquidity. On the other hand, as capital velocity slows, as it does in highly volatile markets, the flow of capital becomes more viscous, market structure breaks down, and the ability to finance operations and assets declines.
“The combination of increasing volatility and decreasing liquidity contributes to periodic inefficiencies and investment opportunities. So, here we are in a market with new, large players who have different mandates and expectations, contending with opaque rules and structural impediments for liquidity and stability when we might need them the most.”
Standish managing director of global fixed income and co-chief investment officer, Raman Srivastava agrees. He says liquidity has become a real focus for bond investors, contributing to some of the periodic sell-offs in areas of debt markets in 2015. “It’s not necessarily Treasuries or traditional bonds that are the issue. It’s more those parts of the market that are susceptible to large flows such as ETFs or mutual funds,” he says.
“Some of it has already happened. Where you see it show up the most is in credit where you can see US$10+bn come in and out of the market in just a couple of weeks via ETFs or mutual funds – and that can have a material effect on spreads. If money does start flowing out, that can exacerbate a sell-off – as we saw in August and September of 2015. There are certain sectors where that continues to be a particular problem – high yield, for example – and there’s no real solution in sight.”
He continues: “It’s just something people have to be aware of through the coming year. Fund managers can deal with it in different ways. They might respond by holding more cash, for example, otherwise they could look at utilising more lines of credit.”
Srivastava’s emerging market debt (EMD) colleague Urban Larson concurs liquidity will remain a point of focus in his asset class over the coming year. That said, he notes some spells of illiquidity in subsectors or countries can be short lived. In the fourth quarter of 2014, for example, liquidity in Russian sovereign debt dried up, but by January the market had bounced back and by mid-2015 the situation was vastly improved. For Standish, the problem areas with respect to EMD liquidity are more evident in off-index notes, as well as in lower quality, high-risk areas such as smaller local currency markets.
Larson says he expects the highest quality US dollar sovereign bonds to continue to benefit from good liquidity even in the face of market volatility, adding that with respect to local currency bonds individual country liquidity also depends on factors such as internal demand. For example, he notes places such as Colombia and Mexico have large domestic pension scheme demand, creating pockets of liquidity.
At Insight, head of EMD Colm McDonagh agrees the pools of liquidity across the regions in his investment universe can differ substantially. He too contends that some of this is a direct result of increased regulation, which has reduced the market-making capability of many global banks. “We’re seeing not quite a fragmentation but certainly a specialisation of banks in certain regions,” he says. With fewer global, emerging market banks available today, McDonagh says he now deals more with those that have a greater regional focus.
Newton’s global fixed income manager Paul Brain says liquidity has become an important consideration for many bond managers and can play a vital role in asset allocation in the run up to deteriorating credit conditions. However, he notes, it is worth remembering that to generate returns above cash, investors are always trading liquidity and making an investment in something where liquidity can change.
“After a 30-year ‘bull run’ there has been an increasing proliferation of fixed income investments that invariably are managed against a fixed income benchmark,” he says. “These investments are at risk if there is a rush to exit.”
He believes one offset to a significant risk-off event during periods of crisis can be to increase government bond positions.
Entering 2016, where liquidity looks set to remain an issue, Brain’s key liquidity considerations are:
- Is the strategy simple and does it change the balance between more and less risky/liquid assets?
- Does it handle with care assets that purport to offer greater liquidity but may not have been tested, such as ETFs?
- Does it monitor liquidity by testing the market on a regular basis?
The ETF challenge:
By Iain Stewart & Paul Brain, Newton
ETFs have seen phenomenal growth in recent years and now represent almost US$3 trillion of assets.2 ETFs are a type of ‘delta one’ derivative product, so any move in the price of the underlying assets is expected to be mirrored by an identical move in the price of the derivative. On the surface at least, products like ETFs, which are continuously priced and traded on a stock exchange in much the same way as stocks themselves, certainly create an impression of being highly liquid.
However, with ETFs increasingly targeting less well known indices and investing in more esoteric areas, such as emerging-market debt, there is a real risk that, should these funds need to sell large positions in a short period of time following a change in investor sentiment, this could distort the market and increase volatility.
Further dangers may come with ‘synthetic’ ETFs which, instead of actually holding the underlying assets, use derivatives such as swaps to track the underlying index. Swap contracts involve an agreement with one or more counterparties who promise to pay the return on the index to the fund.
The returns therefore depend on the counterparty being able to honour its commitment. Although the counterparty must post collateral against its commitments, there is a danger that, in order to keep costs down, the value of the collateral may be insufficient to meet the counterparty’s obligations in full.
1.BNY Mellon Investment Management EMEA Limited is the distributor of the capabilities of its investment managers in Europe, Middle East, Africa and Latin America. Investment managers are appointed by BNY Mellon Investment Management EMEA Limited or affiliated fund operating companies to undertake portfolio management services in respect of the products and services provided by BNY Mellon Investment Management EMEA Limited or the fund operating companies. These products and services are governed by bilateral contracts entered into by BNY Mellon Investment Management EMEA Limited and its clients or by the Prospectus and associated documents related to the funds.
2.Financial Times: 'Exchange traded funds global assets reach $3tn', 5 May 2015