$30 trillion of assets globally are held by similar open-ended funds.
By Nick Corbishley, for WOLF STREET:
The Bank of England warned on Thursday that “financial stability risks are increasing” from giant open-ended funds, which are estimated to hold some $30 trillion in assets globally. These funds are vast sources of financing for the real economy but can pose a systemic risk since the money often goes into assets that are hard to sell quickly, the central bank said in its latest Financial Stability Report.
If investors in an open-ended fund decide to pull their money en masse, which they’re ostensibly allowed to do at just about any time, the fund could struggle to liquidate its assets in time, especially if those assets are not very liquid.
This is exactly what has happened at the £3.7 billion Woodford Equity Income Fund, where a slow-motion (but accelerating) run on the fund prompted its manager, hedge-fund legend Neil Woodford, to place a ban on redemptions to avoid the risk of a fire-sale of its assets, below market value, against the interest of remaining investors. Since then, hundreds of thousands of investors, including public pension funds, have been unable to access their money.
The Bank of England’s Financial Policy Committee (FPC) already warned in 2015 about “the vulnerabilities associated with liquidity mismatch in funds that offered short-term redemptions while investing in longer-dated and potentially illiquid assets.” But no action was taken.
Now, the FPC says the Bank of England and the Financial Conduct Authority (FCA) will review how funds are able to offer daily redemptions while pouring money into assets that can take weeks or months to sell in an orderly fashion. “This can create an incentive for investors to redeem when they expect others to do so,” the FPC said, adding that this mismatch in liquidity “has the potential to become a systemic issue”.
In the case of Woodford, he was able to circumvent a 10% limit on illiquid assets by bundling up his fund’s unlisted assets and listing them on the minuscule Guernsey-headquartered International Stock Exchange, which has barely any trading activity at all and cannot provide liquidity to illiquid assets.
But it didn’t take long for investors to smell a rat. The total amount under management at Woodford has steadily shrunk by almost two thirds since 2015, from £10.2 billion to £3.7 billion. In early June, a request by Kent County Council to withdraw £250 million — the equivalent of around 4% of the total investments of its £6.4 billion pension fund — was the final straw. Instead of releasing the funds, Neil Woodford slammed the doors shut.
Bank of England Governor Mark Carney warned last month that funds like Woodford’s were “built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid. That leads to an expectation of individuals that it’s not that different than having money in a bank… This is a big deal. You can see something that could be systemic,” he said.
In the UK alone, there are more than 3,200 open-ended funds managed by nearly 200 Authorized Fund Managers. According to the Financial Conduct Authority, they have total assets under management (AUM) of £1.5 trillion, up from £484 billion a decade ago. At the global level, open-ended funds hold more than $30 trillion of assets.
The Bank of England’s review of open-ended funds will consider the potential pros and cons of having longer redemption periods for funds holding assets that are hard to sell. At the very least, “a funds’ assets and investment strategies should be consistent with their redemption terms,” the bank says. “Such alignment would directly address the structural cause of liquidity mismatch and help prevent problems from arising in the first place, rather than mitigating problems as they crystallize.”
The G-20 sponsored global financial regulator the Financial Stability Board has also flagged concerns that a large enough run on a fund could trigger a destabilizing fire sale of assets. But attempts to coordinate action at the international level have so far come to nothing.
The Woodford Equity Income Fund isn’t the only fund to have suffered major liquidity issues in recent weeks. In June, London-based H2O Asset Management, which is partly owned by French investment bank Natixis SA, saw £7 billion of customer withdrawals after an FT report revealed the firm had poured around £1 billion into illiquid bonds connected to Lars Windhorst, a German financier with checkered history. That, in turn, prompted fund-research adviser Morningstar to suspend its ratings on one of the funds.
As the Bank of England notes, “multiple recent episodes across a range of markets have further illustrated liquidity mismatch in some open‑ended funds”:
- In December 2018, there was the mass withdrawal of $37 billion from open‑ended leveraged loan funds as herds of panicked investors responded to falling leveraged loan prices.
- In June 2016, in the aftermath of the Brexit vote, six commercial real estate (CRE) funds suspended redemptions and nine funds adjusted the prices that redeeming investors could receive in order to account for the pervading uncertainty and wild swings in asset prices.
- In late 2018 and early 2019, UK CRE funds suffered a fresh wave of redemptions , also due in part to uncertainty surrounding Bexit.
All of these episodes, while not large enough to pose a systemic risk, serve as a reminder that a significant mismatch in funds is “a vulnerability that goes beyond any single market or fund type.” And the more that funds stray into less liquid assets, in a desperate hunt for returns, the greater the threat this vulnerability could pose to financial stability. By Nick Corbishley, for WOLF STREET.
Shares of another equity fund plunged 22% suddenly. Other funds under pressure, raising serious questions about just how liquid “equity funds” in the UK are. Read… Liquidity Fears Hit Other UK “Equity Funds” as Investors Remain Trapped in Woodford Fund
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Mutual fund holders – equity, debt and otherwise – can sell at any time. This is absolutely nothing new. How is this somehow news?
As long as there is NO CONTAGION with the Federal Reserve Banks, all hell can break loose. At least that’s what “they” think. Considering the size and interconnectedness of NON Banks, all hell may really break loose.
I may be completely missing your point here – but selling is exactly what Woodford’s investors cannot do.
The reason it is CLOSED is to prevent or stop a RUN.
But any security issued by Woodford will be immediately shunned or given a huge haircut. Liquidity or lack thereof works in wonderful ways.
The ghosts of disasters past Bear Stearn , Lehman are perhaps being foisted upon us in the present in DB and Woodford. When you see The words liquidity and derivative appear in common , tighten your seat belt.
Now that you mentioned it, contagion may affected the liquidity untested ETFs. Let’s see when the stampede begins.
One can get a sense of liquidity of any ETF, watching it’s daily trade volume. It is available daily.
For some, there is hardly any trades, more than in a day or two or a week. If one buys this kind of ETF, without checking ‘under the hood’there may not be any bid for it, for days!
So buyer beware!
The problem with neo-liberalism is that you eventually run out of public money to provide welfare to giant corporations. Unless you keep running deficits …. oh wait.
There is always your friendly tax authority for ensure corporate welfare too!
At this rate they might as well name them
“Liquidty Funds” because they lose money like if they were trying to hold water in their hands.
Mmmm. £1.5 trillion? National health? Social care? Education? Housing? Education? Climate change? Who ( or in the case of corporations) has £1.5 trillion ‘Assets under management’?
BlackRock alone has $6.5 Trillion in assets under management.
Connecting this liquidity risk problems to BREXIT probably is no big deal — the central banks have you covered — not to worry. By the way, why would the Fed cut rates while the equity market is clocking-in record breaking days each week — maybe there’s systemic liquidity risks that add-up to trillions? Nah …
I frequently curse Aldous Huxley, because I always find myself wanting to say ‘It’s a Brave New World’ in all sorts of contexts which would overlabour the phrase. (And yet, even then, I still slip it in under a thin guise, just because I really want to do so.)
I’m just curious about these illiquid assets. What are they exactly?
I’m going to assume not stocks or bonds, or gold or anything like that.
Real estate? NIRP/ZIRP bonds? Bad bets that they hope would be cured with the passage of time? investments in startups?
I am genuinely curious here. I saw the mention of illiquid bonds, but this brings me to the question of how much of that stuff is actually out there? illiquid seems to imply that stuff that nobody wants unless the prices were sufficiently low. But then, that’s just a point that these guys were doing a poor job in picking out investments.
‘ that’s just a point that these guys were doing a poor job in picking out investments’
Search for yield has gone wild, beyond the norm of ‘investment matrix’ I learned and used to follow, prior to ’09! Fundamentals matter very little!
Blame also goes to CBers for enabling the animal’ spirits and speculative fever in investors, go wild unchecked, by artificially lowering the price of the capital! (Front running pays!)
And at the same time suppressing the price discovery. I surmise most of these ‘illiquid’ assets are/were under the private equity concept!
Most Junk (and near Junk) bonds and Leveraged Loan securities are ILLIQUID. Some Equities and ETFs are also not that liquid. Of the ETFs, I think SPY is the most liquid. The most liquid securities are Treasuries but the interest yield is really low. If you can afford to live with 2% then it’s for you.
Ah I see, the usual game with funds. You have to prove that you can have a better yield, or your clients just might stick all their money in an E-trade account, and just buy ETFs.
Lots of fun.
Frantic search for yield: Interconnection of Global Banking system!
[..]US Collateralised Loan Obligations (CLOs) which Bloomberg reports “ballooned to a record last quarter thanks in large part to unusually high demand from Japanese investors”. CLOs are essentially a basket of leveraged loans provided to generally lower rated companies with very little covenant protection. Alarmingly, some US borrowers have used this debt to purchase back so much of their own stock that their balance sheets now have negative net equity. A recent Fed discussion paper shows in the following chart that CLOs were the largest mechanism for the transfer of corporate credit risk out of undercapitalised banks in the US and into the shadow banking sector. Japanese financial institutions have been the underwriter of much of that risk in their search for yield.[..]
https://www.zerohedge.com/news/2018-07-01/tsunami-out-us-clos
https://www.zerohedge.com/news/2019-07-12/theres-no-escape-one-japanese-bank-owns-over-half-trillion-us-corporate-bonds
Back to 2008 scenario:
https://www.youtube.com/watch?v=kEL0g3As2vE
How transparent are equity funds in the UK? I believe in the U.S. major funds have their holdings and percentages listed publicly. But it seems no one knows or will tell what the illiquid investments are composed of, or where they’re located. If so, it would seem to magnify the risks.
Thanks for the piece, it’s good to learn something new such as the existence of the “International” Stock Exchange.
To have an idea of what we are dealing here I paid a visit to their website and checked what securities are traded… and immendiately found 10.8% fixed yield! Great deal if you can look over the fact it’s not rated. And it’s an unsecured issue. And it’s due in 2058.
So now I know Guernsey is where financial radioactive goes to die, and knowing is half the battle.
Precisely. As Nick pointed out, this was just a trick to dodge the liquidity requirements on paper, while in reality it was more like a scam. Almost nothing gets traded on that exchange.
I suggest all readers to check it out: just type “International Stock Exchange Guernsey” in your search engine and prepare to be entertained/horrified.
Some of the stuff traded there is mind-bogginsly hilarious, as is the average mismatch between bid and ask. However the funniest stuff is probably the currency of choice being the British… penny! Gives new meaning to the phrase “picking pennies in front of the steamroller”.
Brilliant, this made me laugh!
Only on a Mickey Mouse exchange like this would would trades made in 2015 be captured on a list of ‘recent trades’ (Glenstone Property plc, if you’re wondering. Traded twice in 2019 so far).
Nick,
Thanks for the update. Much appreciated.
The liquidity mismatch issue will eventually catch up to many bond ETF’s across the globe. Investors love the ease of buying ETF’s just like common stocks but they sure won’t once the run on the funds commences. Gates will go up everywhere and lawsuits will fly.
In this observer’s opinion, those invested in IG bond ETF’s have no idea of the enormous risks they’ve undertaken. For instance, the Vanguard Intermediate-Term Corporate Bond Index (VCIT) has 56% of its portfolio in BBB rated debt and 54% of its holdings mature in 7 to 10 years. The iShares iBoxx Investment Grade Bond ETF (LQD) has 50% in BBB’s and 25% of the portfolio matures in 25 to 30 years.
Liquidity of these Equity Funds is no different to the bank accounts of banks.
If the investors / bank holders all decide to withdraw their funds, there is no liquidity to do so.
Cashboy; i disagree, if a bank tries to fill redemptions, they are not going to force USD (for example) down like redeeming a small cap. So at least the underlying retains its value regardless of the banks liquidity.
Many mutual funds are too big and have liquidity issues. I have been reviewing funds in the UK from M&G which have massive small cap holdings presumably to try and keep up with their benchmark (unsuccessfully). The problem is that they have these holdings across several funds. In one company the holding is over 16% of the company market cap which means ZERO liquidity. This is matched across a few holdings. Mutual funds in a world of benchmarks and passives are taking ridiculous risks to justify their fees and try and match benchmarks.
Problems like these can easily be solved by making funds closed-end and listing them on a stock exchange.
In fact all liquidity problems can be fixed by placing a hoarding fee on cash like they did in Wörgl Austria in 1932.
This caused an economic miracle known as ‘the miracle of Wörgl’.