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The Importance of Being Earnest[1] About Liquidity Risk Management

Commissioner Luis A. Aguilar

Sept. 22, 2015

The fund industry has witnessed substantial changes in recent years, including the rise of novel investment strategies,[2] a growing use of derivatives,[3] and an increased focus on assets that, traditionally, have been less liquid.[4]  Unfortunately, it appears that not all funds’ liquidity risk management practices have kept pace with these developments.[5]

Today, the Commission considers proposing a set of rules and amendments that will help ensure that open-end investment companies—which include mutual funds and exchange traded funds— manage their liquidity risks in a prudent and responsible manner.  The proposed changes will also help attenuate the dilution risks that confront long-term shareholders, and will give investors needed tools to monitor how well funds are managing their liquidity risk.  These proposals are important, because they will adapt our decades-old liquidity regime to the fund industry’s new and vastly altered landscape.  The proposals we consider today are especially timely, for at least two reasons.  First, a study published just last night suggests that U.S. bond funds need to sharpen their methodologies for analyzing the liquidity of their portfolios, because their current methods might be inadequate.[6]  And second, a resurgence of volatility in the bond markets in recent months has, in concert with shifting market dynamics,[7] thrust liquidity concerns in that space to the forefront.[8]

These proposals are intended to foster a rigorous and analytically sound approach to liquidity risk management, while also helping investors to better gauge the ability of funds to fulfill redemption obligations.[9]

Fund Liquidity, What is it Good For?

Why is liquidity such a paramount concern for open-end funds?  The answer lies in the fact that these funds must stand ready each day to redeem an investor’s shares.[10]  This redemption feature benefits investors who want to exit these funds, but at the same time, it places concerns about liquidity risk[11] firmly at the center of fund management.  Virtually every investment decision made by an open-end fund is influenced by its obligation to redeem on demand, at least to some degree.[12]  Funds typically satisfy this obligation by maintaining a pool of liquid assets that can be converted to cash within three days,[13] without a loss of value. 

Needless to say, liquidity risk management is not an exact science.  But, it is vitally important that open-end funds and their advisers get it right.  For if they don’t, it is not just the redeeming investors who could be harmed, but also the remaining shareholders and, in extreme situations, the broader economy.  A fund struggling to meet an unforeseen surge in redemptions may quickly deplete its pool of liquid assets, and be forced to sell less liquid assets at significantly discounted prices.  Indeed, in some cases, assets might need to be sold at “fire sale” prices.  Such forced sales can depress market prices for those assets, which, in turn, can dilute the value of the assets still held by the fund, or by other funds.  The fear is that this could trigger a run on the funds, as investors attempt to preserve the value of their shares by submitting redemption requests before other investors do so.[14]  As we all know, such runs rarely end well for investors—or for the economy as a whole. 

Further complicating matters, liquidity risk management has grown more challenging in recent years as investment strategies have evolved.  As a white paper prepared by the Division of Economic and Risk Analysis[15] shows, funds have increasingly gravitated towards potentially less liquid assets.  For example, total assets invested in foreign bond funds have grown by more than 1,200 percent since 2000.[16]  Similarly, alternative mutual funds, which hold only 30 percent of their assets in equities on average, are the fastest growing segment of the fund industry.[17]  And, assets in domestic bond funds have increased by more than 130 percent since 2007,[18] even as concerns about deteriorating liquidity in the bond market have grown more acute.[19]  The extent to which the fund landscape has shifted is illustrated by the fact that open-end mutual funds investing primarily in U.S. equities now represent only a minority of total industry assets.[20]

Experts believe that the growing focus on potentially less liquid assets could make runs more likely—and raise the stakes if one occurs.  As a recent study by the International Monetary Fund (IMF) has shown, forced sales of less liquid assets can have a greater impact on market prices than sales of more liquid assets.[21]  This creates an additional incentive for shareholders to redeem as early as possible, as a fund’s remaining shareholders may incur even steeper losses.  The IMF study also points to other factors that could make runs more likely in today’s environment.  For example, the report notes that herding behavior among investors has intensified in recent years, especially in the retail fund space.[22]  This suggests that one investor’s decision to redeem may now be more likely to spur other investors to do the same.  These are ideal conditions for a run to take hold.

Today’s Proposals

So, how does the Commission address the liquidity challenges of open-end funds in today’s more complicated environment?  Today’s proposals represent a multi-faceted approach to these problems.  I won’t go through all of the proposals, but I would like to highlight certain aspects that are noteworthy. 

  • Liquidity Risk Management Program:  The proposal would, for the first time, require open-end funds to establish written liquidity risk management programs.  Such programs would require funds to assess their liquidity risk against a non-exhaustive list of criteria, and to revisit these assessments periodically.   
  • Liquid Asset MinimumAnother core element of the proposal is that funds would be required to maintain a minimum level of highly liquid assets.  Specifically, funds would be required to determine the percentage of their total holdings that must consist of assets that can be converted into cash within three days. 
  • Swing Pricing:  To provide funds with the ability to ensure that investors bear the costs of exercising their redemption rights—and not pass on those costs to remaining shareholders—the proposal would permit funds to adopt partial swing pricing.  This mechanism allows a fund, if its Board of Directors deems it appropriate, to adjust its NAV to account for the costs associated with redemptions and subscriptions above a certain threshold. 
  • Enhanced Disclosure Requirements:  The proposal would also require funds to disclose more information about their liquidity risk management efforts, including the size of their three-day liquidity minimum. 
  • Redemptions-in-Kind:  Finally, the proposal will remedy the oversight that funds are currently not required to have written policies and procedures to govern in-kind redemptions.  In-kind redemptions may be rare, but advanced planning will keep funds from having to scramble to deal with them, if and when they take place.

These proposals recognize that liquidity risk management is a nuanced and dynamic process, one that resists a cookie-cutter approach.  Accordingly, the proposals largely avoid an overly prescriptive method, and opt for guideposts that funds must follow in managing their unique risks.  Notably, the proposal seeks comment on whether the Commission should take a more prescriptive approach with respect to certain types of funds that may present more risk.  This is a crucial question, and I hope that commenters will provide thoughtful views on this point.  Finally, the proposals will also require funds to make more fulsome disclosures about their liquidity risks.  This additional transparency should help to make runs less likely.

Conclusion

I will conclude by noting that investors of all types rely heavily on open-end funds to meet their savings and investment goals.  By helping to ensure that such funds focus on how to remain liquid, even in times of market stress, the proposals will directly advance the Commission’s mission of protecting investors and facilitating capital formation.  I will, therefore, support the recommendation.  

Before I finish, I would like to call attention to the staff who worked so hard to craft these proposals.  The staffs of the Division of Investment Management, the Division of Economic and Risk Analysis, and the Office of General Counsel have all worked diligently in drafting this release, and in answering my office’s many questions.  I appreciate your efforts on behalf of the American public.

Thank you.



[1] Oscar Wilde, The Importance of Being Earnest (1895).

[2] Many mutual funds are now engaging in alternative investment strategies and using derivatives.  Report of the Mutual Fund Directors Forum: Board Oversight of Alternative Investment (Jan. 2014) available at http://www.mfdf.org/images/uploads/newsroom/Board_Oversight_of_Alternative_Investments_-_January_2014.pdf.

[3] See Investment Company Act Release No. 29776, Use of Derivatives by Investment Companies under the Investment Company Act of 1940 (Aug. 31, 2011)(noting “The dramatic growth in the volume and complexity of derivatives investments over the past two decades, and funds’ increased use of derivatives . . . .”), available at  https://www.sec.gov/rules/concept/2011/ic-29776.pdf.

[4] For example, as interest rates have fallen to record lows in recent years, mutual funds and exchange traded funds have increased their holdings of leveraged loans substantially, from only $20 billion in 2008 to roughly $113 billion in 2014.  See Peter Eavis, Mutual Fund Industry May Face New Rules, The New York Times (Dec. 11, 2014), available at http://dealbook.nytimes.com/2014/12/11/mutual-fund-industry-may-face-new-rules/.  In addition, foreign equity funds have experienced significant inflows in recent years, as have long-duration bond funds.  See 2015 Investment Company Fact Book, Investment Company Institute, available at http://www.icifactbook.org/pdf/2015_factbook.pdf.

[5] See Securities Act Release No. [TO COME], Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release  (Sept. 22, 2015) (noting that “the Commission is concerned that some funds employ liquidity risk management practices that are substantially less rigorous,” and that “some funds . . . do not take different market conditions into account when evaluating portfolio asset liquidity, and do not conduct any ongoing liquidity monitoring.”), available at [LINK] (hereinafter “Liquidity Release”). 

[6] Matt Wirz and Tom McGinty,  The New Bond Market: Some Funds Are Not as Liquid as They Appear, The  Wall Street Journal (Sept. 21, 2015), available at http://www.wsj.com/articles/the-new-bond-market-some-funds-are-not-as-liquid-as-they-appear-1442877805.   Notably, this article was published at 7:23 p.m. Eastern Time on the eve of today’s open meeting.

[7] Dealers have traditionally served as the principal source of liquidity in the bond markets, but that is now changing.  For example, according to Federal Reserve data, dealer inventories of municipal bonds have fallen by 65 percent since the end of 2007.  Fitch Ratings, Bond Market Liquidity Seen Moving Toward Asset Managers (Nov. 11, 2014), available at https://www.fitchratings.com/gws/en/fitchwire/fitchwirearticle/Bond-Market-Liquidity?pr_id=920315

[8] Judith Evans, Bond liquidity risks top fund managers’ agenda, Financial Times (May 15, 2015), available at http://www.ft.com/intl/cms/s/0/81eb96e0-fa3f-11e4-a41c-00144feab7de.html#axzz3m2zYTesP.

[9] Section 22(e) of the Investment Company Act describes funds’ obligations with respect to redemptions.  See 15 U.S.C. § 80a-2(a)(41).

[10] John Morley, The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation, 123 Yale L. J. 1118 (Mar. 2014), available at http://www.yalelawjournal.org/article/the-separation-of-funds-and-managers-a-theory-of-investment-fund-structure-and-regulation.

[11] The proposal defines the term “liquidity risk” as “the risk that the fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.”  Liquidity Release, proposed Rule 22e-4(a)(7).

[12] Investment Company Institute Comment Letter to FSOC, Notice Seeking Comment Asset Management Products and Activities (FSOC-2014-0001), 11 (Mar. 25, 2015), available at https://www.ici.org/pdf/15_ici_fsoc_ltr.pdf.

[13] The vast majority of open-end funds are redeemed through broker-dealers.  As a result, they must meet redemption requests within three business days, because broker‑dealers are subject to rule 15c6-1 under the Securities Exchange Act of 1934, which establishes a three-day (T+3) settlement period for security trades effected by a broker or a dealer.  17 CFR 240.15c6-1.  See also Investment Company Institute Comment Letter to FSOC, Notice Seeking Comment Asset Management Products and Activities (FSOC-2014-0001), 17 (Mar. 25, 2015) (noting that “as a matter of practice [mutual] funds typically pay proceeds within one to two days of a redemption request”), available at https://www.ici.org/pdf/15_ici_fsoc_ltr.pdf.   

[14] Paul Hanouna, Jon Novak, Tim Riley, Christof Stahel, Liquidity and Flows of U.S. Mutual Funds, U.S. Securities and Exchange Commission, Division of Economic and Risk Analysis (Sept. 2015), available at [LINK].

[15] Id.

[16] Id. at 7.

[17] Id. at 1, 11.

[18] See Liquidity Release at 25.

[19] Judith Evans, Bond liquidity risks top fund managers’ agenda, Financial Times (May 15, 2015), available at http://www.ft.com/intl/cms/s/0/81eb96e0-fa3f-11e4-a41c-00144feab7de.html#axzz3m2zYTesP.

[20] Paul Hanouna, Jon Novak, Tim Riley, Christof Stahel, Liquidity and Flows of U.S. Mutual Funds, U.S. Securities and Exchange Commission, Division of Economic and Risk Analysis, 4 (Sept. 2015), available at [LINK].

[21] Global Financial Stability Report: Navigating Monetary Policy Challenges and Managing Risks, International Monetary Fund, 105 (Apr. 2015), available at http://www.imf.org/external/pubs/ft/gfsr/2015/01/pdf/text.pdf.  The IMF study confirmed that mutual fund asset flows can affect asset price dynamics, and that this effect is magnified in “smaller, less liquid markets.”  Id.  Specifically, the IMF study found that surprise fund flows have a “significant impact” on asset returns in emerging markets and, to a lesser extent, the U.S. high-yield bond market and the U.S. municipal bond market.  Id. at Table 3.2.  The IMF study also found that surprise fund flows can have a significant impact on asset returns in liquid markets in some circumstances, such as the U.S. bond market between 2008 and 2010, and the U.S. equities market between 2012 and 2014.  Id.  Interestingly, the IMF study found that the “price impact of surprise flows is significantly larger when global risk aversion (as measured by the Chicago Board Options Exchange Market Volatility Index, of VIX) is high.”  Id.  This suggests that the dilutive effects of shareholder redemptions would be more pronounced during periods of market turmoil.

[22] Id. at 112-14.

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