A recent report by the European Central Bank (ECB) showed that the total net assets of funds predominantly invested in less liquid assets reached nearly €1.2tn (£1trn, $1.28trn) in 2021.
This level of exposure is a “worrying sign”, said digital asset manager Collidr.
Combined with the recent collapse of First Republic, along with Credit Suisse and Silicon Valley Bank (SVB) in March, this has highlighted the importance of IFAs understanding the liquidity risks of the funds in which they invest their clients’ money.
Although it can take on many forms, from the gating of real estate funds or depositors chasing higher yields, to the Woodford scandal, liquidity risks are becoming more pronounced and rising in the market environment.
Symon Stickney, chief executive of Collidr, said that liquidity concerns should now be high on IFAs’ agendas.
The big questions to fund managers about liquidity risk should not just cover liquidity in normal market conditions, but also in abnormal ones.
Collidr said that these are the questions IFAs and other investors should be asking fund managers:
- How fast do the fund managers say they can liquidate their holdings in an asset class, and are those estimates reasonable?
- How do they plan to liquidate their positions, and do they have experience at liquidating a position of that size?
- How do their internal compliance and governance functions monitor for liquidity risks?
- Can they clearly define what liquidity means? – e.g., most express ownership as a percentage of market capitalisation but what matters is what percentage of the free float liquidity the fund holds.
- Are the returns being generated by taking excessive liquidity risks, i.e., investing in assets that offer better returns precisely because they are illiquid?
- What kind of premium are they getting for reducing liquidity in the portfolio, and is it worth the extra risk?
Stickney added: “Although we do not believe the current market is the same as the financial crisis of 2008, First Republic, SVB and Credit Suisse are a wake-up call that liquidity is a major risk that should not be underestimated.
Every IFA needs to understand their clients’ exposure to liquidity risk, from satellite holdings in real estate and private equity, to simply investing and holding cash in a bank account. For funds, they should be asking their managers some very searching questions.
“The biggest thing IFAs need to understand is what premium are they getting for reducing the liquidity in their portfolios, and whether this risk is worth it.
“IFAs should be looking at their clients’ portfolios with lens on possible ‘pockets of liquid sensitivity’ within asset classes. Recent examples of this include longer-dated bonds, or over-reliance on technology micro-caps as a source of returns.
“Unfortunately, it normally takes a big crisis for liquidity risks to be noticed, and that’s usually after anything can be rectified. When the markets are falling, and everyone heads for the exits, that’s when you realise how dangerously narrow the door is.”