The mismatch between daily liquidity and the time it takes to liquidate portfolios is exposing the fund management industry to the type of ‘runs’ more traditionally seen in the banking sector, according to Ruffer LLP chairman Jonathan Ruffer.
Fund liquidity issues have come into greater focus recently after the poor performance and subsequent outflows from Neil Woodford’s flagship LF Woodford Equity Income fund.
The issue has been raised by the Bank of England’s Financial Policy Committee (FPC) in its latest financial stability report, which took a closer look at liquidity in the open-ended fund space.
“Large‑scale redemptions from funds could result in sales of illiquid assets that may exceed the ability of dealers and other investors to absorb them, amplifying price moves, transmitting stress to other parts of the financial system and disrupting the availability of finance to the real economy,” wrote the FPC.
While studies have largely focused on other asset classes such as corporate bonds and property, the gating of the LF Woodford Equity Income fund showed that equity funds could also be affected too.
Source: Bank of England
“While these episodes did not have consequences for financial stability, they illustrate that a liquidity mismatch in funds is a vulnerability that goes beyond any single market or fund type,” the FPC added.
“This vulnerability could create financial instability under severe stress and is likely to become more important if more funds expand into less liquid assets.”
After two recent high-profile blow-ups in Woodford and H2O Asset Management, Ruffer said the potential for a run on funds is more likely.
“We are told that more than $30trn of global assets are held in investment funds that promise daily liquidity to investors, despite investing in potentially illiquid underlying assets,” he said.
“What happens when everyone wants to leave at the same time?”
He added: “In days gone by, it was the banks which needed to worry about the queues snaking out of the portals of the buildings and on to the street: death by popular acclaim.
“Now it happens out of public view, and in a different sector: the fund management industry.”
Investment veteran Ruffer said that the way markets operate now has exacerbated the issue.
“The interconnectivity of markets, and the sophistication with which systematic trading machines can target assets and amplify the vulnerability is inherent in this mismatch,” he explained.
“It is a greatly unpleasant thing to see the playing out of a modern day ‘run on a bank’, but the lesson it should instil is that there are not many steps from the particular to the pandemic.”
While funds have in the past been able to avoid such ‘runs’, Ruffer said that ultimately every investment is illiquid “in circumstances where there is a powerful and irrational desire to liquidate holdings”.
He added that algorithmic trading tackles illiquidity head-on, so that the most liquid markets become the most dangerous because they provide “possibly even for a few minutes, the ability to trade after the game’s over”.
Source: Investment Association
This, he said, has been seen in the exchange-traded fund (ETF) space, which he described as the “autobahn of the investment journey”.
“They are a great blessing in peacetime, but they can speed unwanted traffic in the opposite direction when the wars start,” he explained.
While passive products have “utterly transformed” the investment world and have come to dominate markets, Ruffer said the size of the sector in stressed circumstances becomes a weakness rather than a strength.
“What happens when nobody wants them?” he asked. “Or, more starkly, what happens when the vestal machinery gives them the thumbs down?
“Then, only then perhaps, the investor wonders why equities are the preferred investment?”
At this late stage of the cycle, Ruffer said that whatever causes the next market dislocation, the “conduit” will be illiquidity and one of the key determinants will be levels of debt.
“A bank failure always involves debt, and is always toxic,” he said. “At its simplest, an investor whose portfolio decreases in value simply loses the amount in the diminution of its value – much less toxic. But it is no longer as simple as that.
“In the last 30 years, debt has increased both in terms of the number of different ways that an individual or corporation can take on gearing, and also, attitudinally, on a willingness to do so.”
This situation has been inflated by post-financial crisis quantitative easing (QE), which has driven the cost of servicing debt down sharply.
“Debt is a habit, and like all habits, if it begins early, perhaps as a means to fund further education, it becomes domesticated,” he said. “A liquidity crisis strikes at the heart of this homeliness as debt doesn’t take a holiday.
“A trend started by the technique of computer programmes is exacerbated by the emotion of individuals living in a new, and considerably less benign, environment.”
This, he cautioned, needs addressing.
Quoting colleague and chief investment officer Henry Maxey, Ruffer noted that in a stressed market environment, any de-risking of portfolios is likely to be concentrated in the most liquid markets where machine trading dominates and a “sharp, rapid and discontinuous drop” in asset prices can be expected.
Although it might be tempting for investors to sell up and await market events, said Ruffer, it would be the “financial equivalent of the baked beans in the bunker mentality” and is not to be recommended.
As such, the veteran investor said it takes a ‘sword and shield’ approach to protect investors. The ‘shield’ ensures liquidity considerations are at the centre of its investment process, while the ‘sword’ takes a more active approach to illiquidity.
“The conditions which cause a buyers’ strike in the market driving prices frighteningly down are also the conditions which create demand elsewhere,” he noted.
So far this year, LF Ruffer Total Return – a £3.3bn multi-asset fund overseen by FE Alpha Managers David Ballance and Steve Russell – is up by 5.52 per cent compared with a rise of 9.23 per cent for its average IA Mixed Investment 20-60% Shares peer.
Performance of fund vs sector under managers
Source: FE Analytics
Since Ballance and Russell took over in October 2006, the fund has made a return of 118.44 per cent against a 66.46 per cent gain for its average peer. It has an ongoing charges figure (OCF) of 1.22 per cent.