Last Updated: 4 December 2023
The big debate over ETFs’ replication methods and their associated risks looks to be over. Having lost major ground in the competitive battle for investors’ hard-earned cash, Lyxor and Deutsche Bank have just announced they’ll be shifting to physical replication for some of their ETFs.
“This is the best outcome we could have hoped for,” one official involved in the fierce debate over ETF-related risks told me yesterday.
But another key regulatory debate, one which reaches far beyond ETFs, is just starting.
That’s liquidity risk and the potential for funds to run into trouble if they are unable to deal with clients’ redemption requests.
In a consultation report put out earlier this year, IOSCO, the international body coordinating the work of securities market regulators, made the point that collective investment schemes (funds) differ fundamentally from banks in that “maturity transformation” (borrowing short-term and investing long-term) isn’t an inherent part of the business.
Banks do that every day (and are leveraged to boot), but funds may simply do low-risk things like invest in a spread of large-capitalisation, liquid equities, for example. Unlike banks, funds also don’t guarantee that investors will get back what they put in.
But there are grey areas.
US-based, constant-NAV money market funds (MMFs) came close to triggering a wholesale panic at the time of the Lehman collapse and had to be bailed out at huge expense to the American taxpayer, precisely because investors had thought that their invested principal couldn’t fall below a dollar a share.
Money market fund operators and investment banks, which rely on MMFs as a source of financing, have fought fiercely against regulators’ proposals to force these funds to hold a capital buffer or to switch to a floating price, but now appear to be losing the battle.
And there are funds which are marketed with the promise of immediate liquidity but which then go on to invest in less liquid underlying assets. The concern here is that if investors want to withdraw their money in a hurry, they will be unable to do so and a panic could also ensue.
Currently fund liquidity management is dealt with in an unsatisfactory, piecemeal way. Europe’s UCITS framework, for example, is based on the premise that you can sell a fund and get your money back in three days.
And yet if you look into many UCITS funds’ prospectuses you’ll find that they have redemption “gates”, limiting withdrawals from a typical fund to 10 percent of its assets, per day. There are no Europe-wide rules in this area: redemption gates are typically rubber-stamped by national regulators, who see them as a pragmatic solution to potential liquidity concerns.
You won’t find potential redemption restrictions advertised in issuers’ marketing literature. They are there, nevertheless. Your right to getting money out of a UCITS is not unconditional, and don’t expect the fund issuer to step in to rescue you if too many clients want their cash back in a hurry, causing a logjam.
And there are signs that the regulators are preparing to allow for more drastic measures to control redemption pressures. IOSCO, in its April consultation report, mentions the need for funds to have exceptional measures in place to manage liquidity risk. These measures may include lock-up periods, “side pockets” and even a general suspension of outflows.
Side pockets, widely used by hedge funds in 2008/2009, allow for illiquid assets to be separated from liquid ones and for a new fund to be created with the liquid part of the portfolio. You may have to wait years to receive your money, or more likely a small part of it, from the side pocket.
IOSCO is due to release its recommendations for fund liquidity management before year-end.
The European Commission, in its July consultation paper on UCITS, also talks openly of allowing fund managers to suspend redemptions and create side pockets.
None of these potential measures sit easily with the original idea behind the UCITS brand. For ETFs they stick out like a sore thumb, given that the whole idea behind such funds is that you can trade at the click of a button and take your money out at will.
For a fund to suspend redemptions in this way could clearly create a panic and place major pressure on the issuer, even if it is not legally obliged to step in.
Worse, heavy outflows from a fund create incentives for managers to sell the most liquid assets of the fund first, jeopardising the interests of those remaining.
“One of the dirty little secrets of UCITS is that you meet redemption requests by selling your most liquid holdings,” a specialist regulatory lawyer told me recently.
“You don’t respond by taking a strip off the entire portfolio. This does mean that there’s a kind of prioritisation, so to speak, of early leavers. The longer you stay in, the more likely it is you’re going to end up as a residual investor in a fund, all of whose liquid holdings have been sold.”
If your UCITS fund or ETF invests in liquid, large company shares you can probably rest assured. If your fund is full of hot money chasing returns in an area of the market that’s notoriously illiquid in bad times, you should remember you might get stuck if everyone tries to leave in a hurry.
And either way, if you own funds, you should be paying close attention to the next hot area in regulation—liquidity management.