Open-ended funds, as the name suggests, offer investors an accessible entry and exit point to a pool of assets. A fund sponsor issues shares to investors, granting them a stake in the fund’s underlying assets. The value of these shares is determined daily, linked to the fund’s net asset value. Typically, the majority of the fund’s portfolio is comprised of liquid assets, such as publicly traded stocks and government or corporate bonds, ensuring a stable reflection of its value. 

This flexibility allows the fund to expand through asset acquisition and contract when investors acquire or redeem their shares. On redemption, investors get back the value of the shares (adjusted for changes in the value of the assets in the fund) as opposed to the value of their original investment. Consequently, the main risk to a fund is liquidity to meet redemptions on a timely basis. 

The ‘dash for cash’

While open-ended funds are designed to operate smoothly, they face challenges during market downturns. An economic climate characterised by elevated risk typically prompts a shift towards more liquid investments and/or a flight to quality, that is investments that represent a lower credit or market risk. In response, investors rush to redeem their shares in open-ended funds.

Doom loop

This scenario sets the stage for a potential problem known as the ‘doom loop’. As more investors seek redemptions, the fund taps into its liquid assets to fulfil these requests. Once these assets are depleted, the fund is left with no choice but to sell less liquid assets. If multiple funds follow suit, it can trigger market disruptions. Asset prices plummet due to oversupply, creating a cycle of panic and more redemptions.

First-mover advantage

Within this market turmoil, an interesting phenomenon emerges, known as the first-mover advantage. Investors who promptly redeem their shares can capitalise on higher net asset values. Paradoxically, their actions contribute to diminishing these asset values for subsequent redeemers. The cost of their exit is absorbed by other investors, who face a lower net asset value.

Fund interventions

In the past, funds have relied upon measures such as suspending redemptions or gating them to be better placed to realise liquid assets in a manner that does not significantly depress asset prices. However, this often only serves to perpetuate the doom loop. Ratings agencies are minded to mark funds down. This spooks a wider pool of investors, leading to greater demand for redemptions. 

Swing pricing

Another measure funds employ to address the first mover advantage head on is swing pricing. This mechanism comes into play when a fund experiences net redemptions that exceed a certain threshold. 

Swing pricing essentially imposes a cost on investors seeking to redeem shares by adjusting the net asset value (NAV) of their holdings downward. This adjustment reflects the expense incurred by the fund in selling off assets to meet redemption demands. These costs can be explicit (for example, transaction fees, commissions and taxes) or implicit, arising from discounts due to large-scale asset sales.

Vertical slice approach

One form of swing pricing that has recently gained attention involves considering the discount that may be applied if a pro-rata slice of the fund were to be sold off. When a fund faces redemption calls, the natural inclination might be to sell its most liquid assets first, those that are publicly traded and have high daily trading volumes. 

These assets can be sold quickly and absorbed by the market, making them less likely to incur substantial discounts. However, this strategy can leave subsequent investors with a portfolio of less liquid assets, where the cost of liquidation is significantly higher.

Swing pricing that takes a vertical slice of the fund essentially accounts for the cost that would be incurred if the entire spectrum of both liquid and illiquid assets were to be realised in proportion to the percentage of shares being redeemed. 

This approach attempts to level the playing field in reducing the first-mover advantage, as the costs of realising both liquid and illiquid assets are factored into the NAV a redeeming investor receives. As a result, swing pricing discourages hasty exits and encourages investors to weather market uncertainty.

Enter the regulators

In response to issues within funds over recent years, regulators have been looking into the efficacy of tools such as swing pricing and, more generally, examining the state of governance and risk management within the fund sector in its ability to weather periods of fund or market stress. 

A comprehensive multi-firm review of liquidity risk management practices in the asset management industry by the Financial Conduct Authority (FCA) shed light on areas that require improvement, as well as highlighting best practices that can serve as a roadmap for firms. 

The review assessed controls, governance, liquidity stress testing, redemption processes, liquidity management tools and valuation processes, and its scope also went beyond open-ended funds to cover asset managers, authorised fund managers and investment and portfolio managers.

Governance

The FCA review revealed that many firms did not give adequate attention to liquidity management in their governance structures. Liquidity risks were often discussed only in exceptional cases, and therefore failed to give firms a holistic perspective. 

However, those that established dedicated liquidity risk management committees demonstrated a superior approach to managing liquidity risks. Having a liquidity risk appetite statement and documented protocols for governance actions during volatile market conditions were also indicative of effective governance practices.

Liquidity stress testing 

Approaches to stress testing methodologies varied significantly among firms. Some used sophisticated models, while others relied on basic tick-box exercises. Many firms assumed the most liquid assets would be sold first in their models, which can distort the view of real portfolio liquidity. 

The review emphasised the importance of adopting a ‘pro-rata’ methodology to more accurately reflect liquidity during stress scenarios. Furthermore, stress test results varied widely among firms, suggesting that some thresholds and triggers may not be sufficiently challenging to reflect volatile market conditions.

Redemption processes

Most firms had processes for both small and large redemptions, but there was limited oversight to ensure fair treatment of investors, particularly in stressed scenarios. Only a minority of firms rigorously assessed the impact of redemptions on liquidity and held investment managers accountable. Effective frameworks included internal triggers for enhanced governance, fair treatment assessments and consideration of alternative solutions for large redemptions.

Liquidity management tools

There was inconsistency in the use of swing pricing across the industry, with thresholds and pricing adjustments varying widely. The review highlighted the need for dynamic adjustments of thresholds and pricing, as well as back testing to improve swing pricing processes. Over-reliance on third-party administrators was also a concern, echoing findings from a previous review.

Valuation

Valuation processes for mainstream open-ended funds were generally robust, with separate valuation committees and defined processes for less-liquid positions. However, internal challenges to valuations were rare. The review recommended the presence of an independent Valuation Committee, line-by-line interrogation of less liquid positions, and tracking and challenging third-party valuation services.

Expectations from firms

The review emphasised the importance of good governance, robust governance arrangements, and the need for asset managers to ensure fair treatment of both exiting and remaining investors during redemptions. Firms were encouraged to work with service providers to ensure operational systems and processes were fit for purpose and scalable. Consistent use of liquidity stress testing and liquidity management tools was also stressed.

• Reuben Wales is Head of Financial Services, ICAEW