In the July financial stability report, the FPC name checked Neil Woodford’s suspended fund as it stressed liquidity mismatch in open-ended funds was a global issue.
Open-ended investment funds globally play an increasing and important role in the provision of finance, the report said. “The FPC’s in-depth assessment of open-ended funds in 2015 had highlighted the vulnerabilities associated with liquidity mismatch in funds that offered short-term redemptions while investing in longer-dated and potentially illiquid assets. Such funds now held more than $30trn of global assets.”
Bank of England reveals joint review with FCA
It revealed the Bank of England will work with the Financial Conduct Authority to assess the examine the fund structure. The review will assess costs and benefits of aligning pricing and notice periods with the liquidity of the underlying assets in both in normal and stressed market conditions.
Measures already in place to deal with liquidity mismatch, such as swing pricing and suspensions, would also be assessed, although the Bank of England indicated a preference for solutions that “prevent problems from arising in the first place, rather than mitigating problems as they crystallise”.
Property, bonds and now equity funds under the microscope
The Woodford suspension had highlighted the fact liquidity mismatch was not limited to areas where the financial policy committee had previously focused its attention, such as commercial real estate, corporate bonds and leveraged loans.
Alongside the Brexit property fund suspensions, the financial stability report also referenced net selling of sterling corporate bonds by funds in late 2018 and early 2019, whereby market dealers had supported market functioning as net buyers. At the same time, investors redeemed $37bn from the $200bn leveraged loan funds market.
Additionally, UK direct property funds again faced significant redemptions around the turn of the year due to Brexit uncertainty.
ETFs off the hook for now
However, the FPC played down the risks in ETFs despite the fact around a third are invested in assets other than “highly liquid developed economy equities”, which is presumably a reference to bond ETFs.
This was due to the secondary market in ETFs, which meant that despite the fact they could trade at a discount in times of stress, the underlying assets would not be subject to the same fire sale pressure. The FPC said it would review ETFs as part of its annual assessment but judged that the fund structure did not currently present “material financial stability risks”.
Woodford has previously been critical of ETFs as a fund structure stating it encourages short-termism in markets. In December 2017, he described “gigantic” inflows into ETFs as a flashing red light that indicated markets were in a bubble.
In November 2016, he described ETFs as short-term strategies that “are not really ‘investing’ – not in the sense of the word that I understand”.
Liquidity mismatch extends beyond the UK
The existing approach to financial stability risks in open-ended funds is fragmented despite the fact the Financial Stability Board examined the fund structure in 2017, the financial stability report said.
In light of the review, the FSB recommended redemption terms should be consistent with fund assets and investment strategies.
However, subsequently, implementation was left to national authorities and the funds themselves thanks to the International Organization of Securities Commissions (IOSCO), which failed to prescribe how the FSB’s recommendations should be implemented.