Buckets of Liquidity
Liquidity risk is widely considered one of the most prominent potential systemic risks emerging from the sector. Providers of investment vehicles like mutual funds allow investors to readily buy or sell shares of the fund. The actual assets that funds invest in, however, can be highly illiquid and take days or weeks to find buyers for (e.g. bank loans, which now account for more than $100 billion of ETF and mutual fund holdings). If enough fund investors suddenly decide they want to redeem their shares, the situation could escalate to a fire sale scenario with implications for liquidity as asset prices adjust.
This fear became reality in December, when Third Avenue Management closed its $800 million highly speculative Focused Credit Fund and barred investor withdrawals, allowing time to liquidate the fund. Investors who thought they could instantly redeem their shares were unpleasantly surprised.
If the SEC wasn’t already zeroing in on fund liquidity, it is now. Undoubtedly motivated by the Third Avenue incident, it said last Wednesday that it would collect more details on high-yield fund holdings and investor redemptions. The commission is also accepting comments on a proposed rule that would, among other things, require funds to report on the liquidity of their portfolio assets.
That rule correctly recognizes that liquidity is not a binary, “liquid vs. illiquid” phenomenon, but a continuum. The proposal requires funds to determine how long it would reasonably take them to sell assets without materially affecting prices and report how many of their assets fall within each liquidity “bucket,” with buckets designated by the time required for a sale—one day, two to three days, etc.
One challenge is that these determinations are ultimately subjective. Liquidity managers could be expected to come up with widely varying estimates of the time it might take to unload a high-yield bond or foreign stock. Fund managers can (and already do) gauge such durations based on ex ante information (such as historical bid-ask spreads and price volatility), but the past doesn’t necessarily predict the future and — as the financial crisis demonstrated— asset markets do freeze up unexpectedly.
So while in theory the reporting requirement would give investors an idea of the fund’s liquidity profile, in practice it could mislead investors into believing they are buying a highly liquid fund that turns out not to be. Trying to make the risks more explicit, in other words, may make investors less witting to the risks they are assuming. It raises the question whether simpler “buyer beware” disclosures are more effective in stirring caution. This is just one example of the difficulties regulators face when trying to identify or measure risk in a dynamic financial system.
The proposed rules have been acknowledged by fund managers as a step toward promoting best practices and assessing marketwide risk. They would have the greatest effect on funds investing in high-yield bonds and alternative assets with less standardized issues that are not traded on an exchange. Equity funds investing in small-cap or foreign stocks may face similar issues, and funds with fewer assets may face higher compliance costs relative to their size.
Whether or not they include buckets, the final rules would be among the first steps in addressing liquidity risk stemming from asset managers, but—judging by the commission’s 2016 goals—they won’t be the last. At what point these risks pose systemic hazards to the real economy is an important and contentious topic. The shutdown of the Third Avenue fund did not lead to the contagion that some people feared, which is reassuring but not proof that it can’t happen. With banks now closely monitored, asset managers have emerged as the next frontier in evaluating threats to financial stability. To what extent asset managers pose systemic risk to the overall economy is a question many of us will be trying to answer.