Regulators increase focus on alternative investment fund liquidity

Financial market and securities industry regulators are increasing their focus on investment fund liquidity, as they aim to reduce the risk that in times of stress or crisis fund manager’s are better able to manage liquidity risk and honour investor redemptions.

With U.S. mutual funds and European UCITS funds offering frequent liquidity opportunities and both fund structures increasingly popular in the insurance-linked securities (ILS) and reinsurance linked investment space, managing liquidity is growing in importance in this sector.

Of course ILS and reinsurance-linked investments are not the most liquid of assets. Catastrophe bonds, at least the 144A variety, have secondary liquidity and a market that functions to allow investors and ILS fund managers to switch in and out of positions. However this is now less than 50% of the ILS market.

The majority of the ILS market is now made up of less liquid, or sometimes completely illiquid, investments in private ILS securitisations, collateralised reinsurance transactions or structures such as reinsurance sidecars.

Some of these are technically liquid, in that they are structured in such a way as to have secondary transferability (so could be bought or sold privately). However the times when an ILS investor or manager may want to sell such an asset, such as when a major hurricane is bearing down on the U.S. coastline, liquidity in even the Rule 144A cat bonds could dry up making this an asset class which is naturally less-liquid than many others when under stress.

So, regulators are focusing on liquidity risks across asset classes, seeking to ensure that end-investors can benefit from the liquidity that a fund advertises or promises it will make available.

The International Organization of Securities Commissions (IOSCO), an international body that brings together the world’s securities regulators and the global standard setter for the securities sector, is among the regulators looking to provide improved guidance to investment funds over how to manage liquidity risk and how managers can be transparent with their investors over the risk and any restrictions they have in place on their funds.

IOSCO’s Board has agreed to publish a report on liquidity risk management across collective investment schemes, to enhance data collection and to consider developing new guidance on liquidity risk management, including stress testing of funds and investment schemes.

Having standards in place for liquidity is important, so that investors understand any restrictions or limits that may be placed on them. U.S. mutual funds investing in ILS may in some cases have stricter rules around liquidity than you may at first expect from a 40’s Act fund, however it’s typically all well documented in prospectus’ which means it’s vital that advisers are educating end-investors and helping them to understand any liquidity risk a strategy could hold.

Meanwhile the U.S. Securities & Exchange Commission (SEC) has proposed rules surrounding liquidity management for mutual funds, open-ended funds and exchange traded funds.

The proposals lay out a “comprehensive package of rule reforms designed to enhance effective liquidity risk management.”

“Promoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds,” commented SEC Chair Mary Jo White. “These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commission’s oversight.”

Under the proposed rules fund managers would have to implement liquidity risk management programs and enhance their disclosure regarding fund liquidity and redemption practices. This would certainly affect the mutual funds which operate in ILS or invest in ILS as part of a multi-asset strategy.

The SEC explains:

A fund’s liquidity risk management program would be required to contain multiple elements, including: classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; assessment, periodic review and management of a fund’s liquidity risk; establishment of a fund’s three-day liquid asset minimum; and board approval and review. In addition, the proposal would codify the 15 percent limit on illiquid assets included in current Commission guidelines.

The ILS investments in mutual fund or UCITS style structures are typically part of the ‘liquid alternative’ investment arena. There has been a significant amount of debate around liquid alternatives and just how liquid they actually are.

Clearly, not all ILS are liquid and the times when a fund manager may want liquidity it may not always be as available as they might hope. Hence guidelines need to be strong from regulators, disclosure by fund managers needs to be transparent and the liquid portions of funds need to be maintained.

As regulator scrutiny of alternative investment fund liquidity increases the investment managers operating ILS strategies which promise liquidity would do well to keep appraised and ensure their disclosures to end-investors thoroughly explain any risk or restrictions to liquidity and how they would manage it.