The fund management sector may lead us into the next global financial crisis

The drama surrounding H2O Asset Management and its investments in illiquid bonds and Neil Woodford’s investment group suspending trading in his largest equity fund in June after it was unable to honour investor withdrawal requests, has put liquidity risk back into the spotlight. For the global asset management industry that it is.

The Financial Times initially reported that Natixis’s H2O asset management arm saw heavy outflows of client cash after Morningstar put its rating on the fund under review earlier this year.

The Woodford Equity Fund, where hundreds of thousands of retail investors’ money is trapped, has received wider coverage.

Both investment houses face heavy exposure to illiquid assets and this follows closely on the heels of Swiss fund manager GAM, which last year halted its SFr11-billion absolute return bond fund range. This was after some investors demanded their money back after the Zurich-based group suspended a top portfolio manager because of concerns about the extent of the fund’s exposure to assets linked to a single financier and the steel industry.

It seems liquidity risk is swiftly becoming the defining issue for asset managers in 2019.

Amin Rajan, the chief executive of consultancy Create-Research, told the Financial Times the cracks in the system are becoming more apparent as investors hunt for decent returns following a decade of low interest rates and disappointing stock market performance.

“Few have focused on the liquidity of the higher-yielding assets,” he said and “recent market jitters have refocused minds”.

For this reason global mutual funds and even exchange-traded funds have moved into more illiquid investments in an attempt to replicate yields of the market’s former glory days.

“It is the fear of missing out (FOMO),” says Mohamed El-Erian, chief economic adviser at international financial services provider Allianz.

“Nobody wants to underperform and even if an initial withdrawal from a fund has nothing to do with its manager, it can serve as a kind of contagion that others follow.”

El-Erian told the BBC he was worried that investors are unaware of the risk they are running into with this mentality. They won’t be able to access their money when they need it most and regulators could be blindsided by the next big crisis, which this herd behaviour can lead to.

He says end-users have become too accustomed to the abundant level of liquidity provided by central banks in the market over the years and adds that money managers need to better communicate with investors to better understand liquidity risk and not just price risk.

“The risk of liquidity has never disappeared,” he says. “It has just moved out of the banking sectors to other parts of the financial sector.”

Some regulators, however, are already pushing for tougher regulations. The European Securities and Markets Authority, Europe’s top financial markets supervisor, told the Financial Times that liquidity “has been a key concern... especially in the prevailing environment of low-interest rates and the search for yield by investors”.

EU regulators told the BBC they are developing liquidity stress tests, similar to the banking sector, which introduced them after the last financial crisis.

The Financial Conduct Authority in the UK has launched an investigation into the events that led to the gating of Woodford’s fund to investor redemptions and it has already raised questions about how the fund liquidity should be defined.

Jean Pierre Verster, who heads up the newly formed Protea Capital, says the reaction might be overblown.

“All it shows is a flaw in the rules governing the proportion of unlisted assets funds abroad,” he says. But, this can quickly be rectified.

“The equity income fund had managed to keep within the liquidity limits by listing stakes in some previously unlisted assets on Guernsey’s stock exchange for example,” he says.

He also stresses how rare it is for funds to breach the EU’s 10% cap on illiquid assets. Of about 3,000 open-ended UK funds, Woodford’s fund and one other small fund were the only two to report a breach in the past year.

The same goes for Regulation 28 of the Pension Funds Act in South Africa, Verster says.

Up to 10% of total funds may be invested either in hedge funds or private equity. Combined exposure to both asset classes is limited to 15% in total. Retirement funds may also invest up to 10% of their assets directly into unlisted equities, rather than making the investment via a private equity fund. BM