An independent group is attempting to deal with the issue of liquidity risk in the asset management industry by producing simple colour-coded charts highlighting the funds where this is a potential problem.
Risk Intelligence produces dashboards and ratings that monitor the risks taken by individual funds in terms of liquidity, currencies, the market and interest rates.
Source: Risk Intelligence
Director Asim Javed launched the company when he realised that many major fund groups he worked with had little in the way of quantifiable and forward-looking risk-management processes.
“About 90 per cent of the time you would hear the same thing: ‘We look at the standard deviation,’ he said.
“Yes, but the standard deviation is after the event. What about the VaR [value at risk] limits, what about the liquidity risk, what about thinking about what you're putting into the portfolio?”
Asset management groups can hire Risk Intelligence to produce monthly factsheets on their funds. Javed said its independence is important as it can take an objective view of the risks facing a fund without having to worry about conflicts of interest.
A good example of this arose last year when he wrote a paper on the performance of many cautious and balanced funds during March’s Covid-related market crash.
“If you look at maximum drawdowns and how these funds were behaving, they were worse than growth funds,” he said.
“One of the potential clients who we sent that email to looked at the report and knew that was its fund that was in the left-hand tail, sitting outside two to three standard deviations.
“It didn't want to acknowledge that, for the simple reason that if it did, it would have had to change its story and if it changed its story the IFAs wouldn't like it and they wouldn't be able to sell its inhouse fund.”
When it comes to liquidity risk, many funds have begun to publicise how many days it would take to liquidate their portfolio. However, Javed said this doesn’t take into account the impact of mass redemptions on the fund.
“If I put a redemption through today for a fund that I want to come out of as a retail investor, it will take T+4 (four days) for that money to arrive into my account,” he explained.
“But at the same time, the fund has to generate that money by selling something. If it is investing in something which can't be sold in T+2 or T+3, that means you're going to have this mismatch problem. And we address that in our liquidity report as well.”
Risk Intelligence’s reports highlight the T+ number for the underlying stocks in each fund and reveal how many days of average and maximum redemptions (based on historical data) it can withstand before it runs into trouble.
Of course, the issue of liquidity was first brought to the fore with the suspension of the Woodford Equity Income fund. Neil Woodford’s announcement this week that he plans to return to the fund management industry led to a sharply worded statement from the FCA saying any such business “would need to apply for appropriate permissions before commencing any regulated activity in the UK”, which would depend on an assessment of “the sustainability of the firm’s business model and the fitness of its management”. It added that it is still investigating the events that led to the suspension of the fund in 2019.
However, Javed said his risk-assessment process highlighted the liquidity problems building in Woodford Equity Income long before things came to a head.
“We were supposed to go and present to Woodford and we were invited to do that in October 2017, I think. But Woodford cancelled two days before. The thesis of that presentation was basically, you have massive risk. And that risk is because of the capitalisation issues.”
Javed said there is now another high-profile fund that is causing him some concerns from a liquidity perspective. While Fundsmith Equity invests predominantly in large caps and more than 40 per cent of the fund’s positions could be fully sold within four days, about a third would take more than nine days. This has led Risk Intelligence to award it a “high liquidity risk” rating.
Liquidity risk in fund
Source: Risk Intelligence
“It’s because of the concentration side,” said Javed. “The way we look at liquidity is together with concentration. It may be in mega caps, but if it's a very big fund and it has a concentrated portfolio, the time it will take to get out of those positions is a problem.
“As soon as you start dumping it on to the market, you won't get T+2, brokers will slice it down into T+6 or T+7.”