The Financial Conduct Authority and Bank of England are reviewing the way open-ended funds operate with regards to liquidity.
The study stemmed from a decision by the Financial Policy Committee (FPC) in 2019 which found a "mismatch between redemption terms and the liquidity of some funds' assets". This means that investors who redeem early find themselves at an advantage compared to others, particularly during stress events, such as the early months of the covid-19 pandemic. The FPC's original recommendations were that:
- Redeeming investors should receive a price for their units in the fund, which reflects the discount needed to sell the required portion of a fund's assets in the redemption notice period;
- The liquidity of funds' assets should be assessed either as the price discount needed for a quick sale of a representative sample - a "vertical slice" - of those assets or the time period needed for a sale to avoid a material price discount; and,
- Redemption notice periods and/or redemption frequency should reflect the time needed to sell the required portion of a fund's assets.
As a result, the FCA and BoE surveyed a range of UK authorised open-ended funds between August and September 2020 to understand their approach to liquidity and redemption, as well as how to advance the three FPC principles.
The two watchdogs said: "Findings suggest that funds have a large number of liquidity management tools available and, if set out in their prospectuses, their managers utilise them, particularly during stress events. "Rules allow for discretion on how these tools are deployed. Swing pricing and other anti-dilution mechanisms were widely applied to incorporate the liquidity costs associated with flows faced by funds during normal and stressed market conditions."
The funds surveyed experienced net outflows in March 2020, which were much larger for funds with predominantly professional investors, and lower for direct retail ones.
While the survey discovered that fund managers demonstrated flexibility in their dilution adjustments and conducted regular liquidity analyses, there were some divergences in the funds' approaches to liquidity management. "Tool selection and trigger points for their usage, and some pricing adjustment calculations, were set across a fund manager's different fund ranges, with lesser regard to the specific investment strategy of the funds and/or the type of assets they held," the FCA and BoE said. "There were significant differences in how similar funds facing similar flows applied swing pricing.
Some fund managers used discretion to switch from partial to full swing pricing. Fund managers reported mainly using bid-ask spreads, followed by explicit costs of the transaction - eg commissions and fees - as the main components in calculating swing factors. "Most funds managers did not factor market impact explicitly into their swing factors.
Few had models in place to estimate fixed-income spreads when needed. Some of the differences in swing factors might be explained by fund-specific characteristics, such as the fund's primary strategy or the liquidity of the underlying assets, or whether the fund experienced net flows. "But there were variations that could not be fully explained by these factors."
Consequently, the two watchdogs have proposed that open ended funds will need to:
- Ensure the time it takes investors to redeem their money matches the fund's ability to sell its assets to meet redemptions;
- Classify their assets according to how easy they are to sell; and,
- Adjust prices to reflect market conditions.
The FCA and BoE added: "This will ensure that there is more consistency between the ease with which investors can access their money and the ease with which a fund can sell its assets.
Such consistency will support financial stability and give greater certainty to investors."