Categorising investment funds by portfolio liquidity is 'counterproductive'

Categorising investment funds according to their portfolio liquidity is counterproductive, the European Fund And Asset Management Association has flagged in a statement on 12 February. 

Since recent market disruptions such as the COVID-19 pandemic, the Financial Stability Board (FSB) and the International Organization of Securities Supervisors (IOSCO) have investigated how to make investment funds more resilient to liquidity shocks.

The FSB published their recommendations in December 2023 and IOSCO is now looking into how to adjust their own 2018 recommendations along these lines.

The new FSB/IOSCO framework emphasises many aspects essential for proper fund liquidity management, like the primary role played by the asset manager and the importance of maintaining flexibility when selecting the appropriate liquidity management tools (LMTs).

However, EFAMA argues that several recommendations unduly restrict asset managers’ ability to adequately run funds:

• Obliging asset managers to pigeonhole funds into three categories based on their liquidity, each requiring different LMTs to manage periods of stress, would require that supervisors impose specific requirements on asset managers’ risk models to ensure consistency across funds. If this results in asset managers having to run several risk models, it would be regulatory duplication. And if this means asset managers can no longer consider their fund’s specificities in their risk models, this would result in lower-quality risk management.

• Anti-dilution tools (ADTs) are valuable as they allocate transaction costs to exiting/redeeming investors, ensuring that funds investing in less liquid assets do not absorb losses from redemptions when markets become volatile. However, ADTs are not always necessary for funds investing in less liquid assets and their daily use could result in additional and unwarranted operational costs for investors, especially if supervisors expect funds to calculate implicit transaction costs before each trade.

• Quantity-based LMTs, which limit subscriptions/redemptions, are equally valuable as they ensure that funds do not engage in fire sales when redemptions exceed reasonable expectations. IOSCO should not recommend that supervisors unduly restrict their use. Providing a list of exceptional circumstances would create expectations among investors when those circumstances arise and uncertainty when a fund is hit by a crisis that is not included in the list. It is also inappropriate to prohibit suspending separately subscriptions and redemptions or using different tools depending on the investors exiting the fund.

EFAMA further reiterates that IOSCO’s focus on fund liquidity management stemmed from unfounded assumptions. The Bank of England (BoE) recently conducted a System-Wide Exploratory Scenario (SWES) Exercise which demonstrated that spikes in liquidity demand during periods of stress mainly originated from margin calls (93%) rather than redemptions from investment funds (7%).

Marin Capelle, EFAMA regulatory policy adviser, said: “European asset managers should not categorise funds depending on their portfolio liquidity. They already conduct extensive liquidity stress tests which can be relied on when assessing the benefits of specific liquidity management tools.

"After a long review of the UCITS/AIFMD framework, introducing this type of fund categorisation in Europe would counter the EU’s simplification objective without any financial stability benefits.”