I’m not an animal lover per se, but I have nothing against them. I like a David Attenborough and National Geographic documentary as much as the next person. But lately animals have been on my mind more so than usual. Or, to be more precise, I’ve noticed myself using animal analogies in discussions on fund liquidity. For instance, the “black swan” event that the COVID-19 pandemic represents. Or the “elephant” or “800-pound gorilla” in the room when describing the mismatch of certain asset class liquidity to investor expectations. This recurring debate on the same issues reminds me of the movie Groundhog Day. Another comparison I could also add would be ostriches with their heads in the sand when it comes to certain fund types (ahem, daily dealing UK property funds) who seem to ignore recurring threats of liquidity mismatches than address them. Of all these analogies, however, it is the “sacred cow” of daily dealing UCITS funds that I find myself muttering about the most.
I will not rehash the events of recent years, but the global asset management industry has been part of a multiyear debate focusing on fund liquidity. Regulators have been raising the bar across the board by introducing measures aimed at mitigating the effects of adverse liquidity events. I am not in the habit of criticizing the UCITS regime – in fact, the opposite. The UCITS regime (coupled with AIFMD & MIFID) have been large contributory factors to my professional career to date and for that I will remain eternally grateful. Even in the face of some of the most volatile market conditions we’ve ever seen, global funds and UCITS funds, in general, have been largely resilient in managing investor redemptions by utilizing the various liquidity management tools at their disposal. But as asset managers face into the ESMA stress test guidelines in September 2020, I raise the question: is there another way? And might one way of alleviating UCITS stress be a move away from daily dealing? We recently discussed the growing focus in asset management on retail investor access to less liquid alternative investment funds for more optionality for the retail segment.
Just because there have been no issues doesn’t mean there isn’t a problem
The fact that there have not been any large-scale liquidity issues might suggest the system is functioning as intended. Managing the recent volatility and redemptions, without question, was a herculean effort across the board. There is no doubt that it can be considered a liquidity success story, and it is also true that if UCITS funds had slightly more latitude in terms of dealing frequency, it would help management of future situations. But here’s the kicker: although the UCITS fund market has shifted almost exclusively to daily dealing, this is a result of commercial rather than regulatory imperatives.
Here’s why: UCITS funds are required to be “liquid,” which in practice means they must be able to meet redemption requests on at least a bi-monthly basis (twice a month for certainty), and redemption proceeds must be paid within a maximum of ten (10) business days after a dealing cut off. The UCITS ruleset also allows for instance of in specie redemptions for large redemptions (some with and some without investor approval) but at that stage there are not many investors who want anything other than cash when exiting the fund. It is possible that “gating” will occur again in UCITS although of insignificant practical use given that for a daily dealing fund, a redemption gate operates until the next dealing day on a pro- rata basis.
That’s Just the Way it is, Some Things Will Never Change
Daily dealing funds basically became obligatory as retail distribution channels grew up. In the UK market, independent advisors offered what was collectively known as managed portfolio services (MPS). This practice led to such portfolios becoming a type of fund of fund vehicle where the MPS composition gave exposure to a wide range of other collective vehicles and the discretionary managers then reallocated these MPS as they went along. Because of the nature of the investors (i.e. retail with low balances in and out) and the underlying investments (fund of funds), the regular rebalancing of the MPS demanded that funds had to be priced daily. As a result, the cult of daily funds is a legacy of funds and other investment solutions wishing to sell to independent financial advisors and onward to retail customers.
As the UCITS wholesale market has grown up, much of its success is attributed to a distribution model based on retail investor access. Retail investors were able to access the funds through aggregation on distribution platforms intermediated by a complex chain of brokers and other intermediaries. As the model grew, so too did the power of the dealing platforms. Since the dealing platforms were primarily built for retail models, they usually involved daily dealing in high volumes. Most of the large platforms are operationally hard coded for daily funds. While they often do have optionality for non-daily dealing funds, the default is daily. In the UK, for instance, there are platforms that only list daily priced funds. As such, often a fund has no option but to have daily dealing to sate its distribution network.
Rage Against the Machine?
Large distribution channels retain a vice like grip on the UCITS marketplace and have a long-held fixation that daily dealing vehicles are a non-negotiable part of that marketplace. It is nearly impossible to attract capital from the retail or wholesale market in Europe without providing daily dealing.
Regulators remain hugely focused on fostering increased long-term patient investing. Policy attempts in Europe to foster longer-term vehicles, however, have to date failed to catch fire and almost all the authorized and supervised UCITS funds remain on daily dealing cycles.
The industry is determined to promote itself as “long-term investing” and yet the UCITS ecosystem almost exclusively promotes daily-dealing funds, while remaining relatively silent on other options and avenues. No one appears willing to even consider whether a UCITS fund could step off the daily dealing roundabout and still succeed by offering (only ever so slightly) more constrained liquidity terms to its investors.
There is rarely consideration given to reducing the number of available dealing days available on a UCITS funds. My memory might not be what it once was, but I cannot recall reading or hearing this mentioned as an avenue to reduce liquidity risk and increase alignment with the investors risk return appetite. The “always open” UCITS mantra is strong, even though the regulatory ruleset categorically suggests that twice a month is perfectly fine.
Now might be the time for the industry to have a conversation with itself to judge whether making a fund daily traded is the right approach for every asset class. There’s a clear liquidity mismatch in pockets of the UCITS market. High yield bond and emerging market asset classes for example, naturally have market settlement, market depth, and liquidity dynamics which always result in the guarantee of daily liquidity in stressed market being a hard promise to keep. It is a known issue and will not go away using the “ostrich head in the sand” technique. Providing weekly or bi-monthly traded UCITS funds shouldn’t be a weakness in the fund itself, nor the UCITS framework. It was designed to provide the flexibility required for asset managers to provide investors with optimal long-term outcomes.
It might be beneficial for the industry to explain to their client base that they simply must accept the fact that if you want to profit from the illiquidity premium, the trade-off is, you can’t just get your money back when you want to, you might need to wait a few days. Asset managers themselves might chip in with a slightly lower fee to further incentivize investors to stick it out for a slightly longer period. The appropriate alignment of incentives is required. That might sound naively simple, but the well documented issues of UK retail property funds begin and end with this mismatch of trade off.
Overall, the problem is the first mover disadvantage. If a fund decided it would shift to bi-monthly dealing, and was the only one to do so, then it’s likely competitors would market themselves against the “less liquid” fund.
So, there are my thoughts on it but more importantly, I am interested in knowing what you guys think of these black swans and sacred cows?