Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
IMF comes out swinging for fund liquidity controls
According to the IMF analysis published last week, daily-priced funds exposed to illiquid assets (such as corporate bonds) could cause a financial system blowout as fund-runs degrade underlying asset values in a doom-loop of selling.
While various jurisdictions employ ad hoc fund liquidity management techniques, the report says the growing size and interconnectedness of the sector requires a global regulatory effort to rein-in risks.
“Competitive pressure and concerns about stigma may prevent funds from voluntarily implementing optimal policy solutions; policymakers should therefore consider mandating the adoption of liquidity management tools and enhanced disclosure,” the IMF paper says. “… Given the global operations of funds and their cross-border spillover effects, liquidity management practices should be deployed consistently at the global level to ensure their effectiveness, which calls for greater international regulatory coordination.”
The daily-priced open-ended fund market has grown almost four-fold since the global financial crisis to hit US$41 trillion, the report says, or about 20 per cent of the non-bank sector.
But funds have also diversified from broader equities and bonds into a range of relatively illiquid assets, leaving some prone to a self-reinforcing run under volatile conditions or loss of investor confidence. Strategies including redemption halts, gates and side-pocketing can help funds manage liquidity issues after the fact but the IMF favours pre-emptive product design features.
“Studies point to the potential effectiveness of price-based measures such as swing pricing, redemption fees, and antidilution levies in reducing investors’ incentive to run on funds,” the paper says. “These measures ensure that trading costs are borne only by the exiting investors, for example, by adjusting the net asset value when facing outflows (swing pricing) or by imposing a fee on redeeming investors (antidilution levies). This is desirable from an investor protection perspective-both in normal times and in times of market stress-because it prevents dilution of the shares of the fund’s remaining investors.”
Swing-pricing should, in particular, limit any ‘first mover advantage’ during periods of high volatility with investors facing an explicit cost for bailing early.
“However, to date, these measures have been adopted only by funds in certain jurisdictions, and there are questions about their calibration and effectiveness, especially in periods of severe market stress,” the IMF analysis says.
IMF report authors, Fabio Natalucci (photo at top), Mahvash Qureshi and Felix Suntheim, note better disclosure and monitoring of fund liquidity risks may also be necessary.
“Furthermore, encouraging more trading through central clearinghouses and making bond trades more transparent could help boost liquidity,” the trio said in an article. “These actions would reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress.”
