Jon Beckett, a UK Research Lead at the APFI, looks at the due diligence questions selectors should ask to avoid running aground when markets turn.
The last 10 years has seen a series of liquidity crunches alongside a growing concentration of assets into a shrinking number of super-sized funds.
In response, the AIFMD and incoming Ucits regulation is forcing fund managers to re-consider the liquidity of their funds.
In this respect selectors should look more closely at how the size of a fund affects its trading viability and its ability to move in and out of different markets.
To explain the challenges these giant funds can encounter a useful analogy is the supertanker ship, a vessel I am all-too familiar with since my father was an engineering officer in the merchant navy.
‘Draft’ is the term used for how deep a ship’s hull sits in the water. When supertankers are fully laden they sit very deep in the water.
Draft creates drag and this has a bearing on how ships handle in different depths and supertankers have long struggled to navigate shallow water.
These giant ships tend to ‘yaw’ rather than steer conventionally, meaning the entire body of the ship moves sidewards as it is trying to turn. The investment equivalent of this manoeuvre occurs when a big fund tries to dump a large amount of assets into the market through program trades.
As the fund exerts a significant impact on the trading volume (and hence price) the order book moves around the fund as much as the fund is able to get in and out of the market.
Often there are insufficient participants to trade the other side of the book with the fund manager, who is then forced to trade out/in progressively and has to accept the shifting price (yaw) on day three in response to his trading on day one.
By owning so much of the market a supertanker fund may become susceptible to unexpected shocks as the trading volume around its positions becomes shallow and therefore even small volumes of trade can have a disproportionate impact on the price of its holdings.
When is a fund too big?
Today’s supertanker funds are built on yesterday’s rules; they were never designed to be so large but have since been adapted to handle high inflows.
A fund can diversify its liquidity through a range of markets but can also manage the liquidity as it deepens and shallows and correlations move towards and away from a delta of 1.
Large-scale QE can quickly disrupt normal patterns, so when it comes to looking at a fund’s return prospects selectors should initially assess the liquidity and depth of market beneath the fund to see whether it has adequate trading capacity.
Using the AIFMD as a template we can start to ask specific due diligence questions to assess the liquidity risk of big funds such as:
- Outline any illiquid, non-daily priced or low volume assets held and how you manage these positions (eg direct property, unlisted stocks).
- What is the maximum size (capacity) of your strategy?
- Have you stress-tested the current portfolio, the liquidity profile of your investors or subjected the strategy to liquidity scenarios?
- What is the maximum percentage of the fund’s assets held by a single client and the ratio of retail to institutional clients?
- What has been the largest weekly and monthly outflow from your fund and what percentage of the fund did this constitute?
- Indicate your current liquidity ladder at normal prevailing prices – how much of the fund you can liquidate in one day, two days, seven days, 30 days, 90 days.
- Are there any sub-sectors where you own more than 10% of that market? Also detail the smallest market and holding (market capitalisation) you are prepared to hold.
- What redemption policies (eg unit cancellation, equalisation, dilution levy, swing-pricing) can you currently employ?
- Provide details of the liquidity of your portfolio, including the type of cash instruments held, trading liquidity of other assets and how quickly 75% of the portfolio can be traded out.
- Highlight and describe any holdings held currently (or previously) in the following: Gold bullion, Commodities, Exchange traded commodities, Traded endowment plans, Milk quotas, Contracts for differences, Direct property, Infrastructure, Cash held for margin requirements, Complex derivatives (eg OTC, non-vanilla Swaps, Swaptions), Unlisted securities (inc private equity, private loans).
When fund managers face increasing inflows they often increase the size of individual holdings. This presents a challenge for the fund selector who must work with the fund manager to understand the liquidity profile of the fund and the redemption profile of the client base. One must match the other and this has to be discovered during the due diligence process.
As fund sizes and regulation grow selectors should take liquidity management and capacity more seriously before investing in supertanker funds and ask the simple questions: how diversified is the fund, how liquid are those positions, what is the maturity profile of those assets and what does the fund’s liquidity management look like?
If you are not comfortable with any answers to these questions then pause before weighing anchor.
Jon ‘JB’ Beckett is an author for the Chartered Institute for Securities and Investments spokesperson and UK research lead member of the Association of Professional Fund Investors and gatekeeper for one of the UK’s largest unit-linked fund platforms. The full paper by JB is available to view on www.profundinvestors.com