Liquidity Risk Management: Going Beyond “Tick-the-Box” Compliance

We enter 2021 the same as we ended 2020, focused on the global COVID-19 pandemic and its recovery, with sustainable investing at the forefront. But another pillar we have seen is the focus on liquidity. In this article we touch on the European Securities and Markets Authority (ESMA) liquidity stress testing guidelines. We stress-tested the data using FactSet’s Portfolio Analysis application, allowing for position oversight and risk monitoring while also demonstrating an original approach of integration into a real-world optimization problem.

Increased Focus Following the Global Financial Crisis

Liquidity risk management has been a growing focus for several years with regulators being a big driver and investors demanding more due diligence from their fund managers. The high-profile case of the Woodford Equity Income Fund brought into focus how important it is to understand the actual liquidity profile of an investment beyond what the prospectus contains. However, managing liquidity risk should not be seen as just a “tick-the-box” exercise but rather should form a regular part of a fund’s risk monitoring as encouraged by the various regulators around the world.

In the years following the 2008 global financial crisis, financial regulators—coordinating via the newly-formed Financial Stability Board (FSB)—identified liquidity mismatch as a structural vulnerability in the asset-management industry, particularly for open-end funds given their redemption terms. Open-end funds, by design, are liquid for investors; their redemption terms enable investors to redeem holdings with minimal notice. In this light, redemption rights can be viewed as a type of liability, and liquidity management as the fund industry’s version of asset-liability matching. Depending on a combination of (i) prevailing market conditions, (ii) fund asset class exposures, including derivatives positions, and (iii) the investor profile of a fund, funds might be required to meet sizable redemptions on short notice, forcing them to close positions in lower liquidity positions. This, in turn, could lead to significant negative market price impacts and additional harm to non-redeeming shareholders.

The financial crisis heightened regulators’ concern about these dynamics. Of the FSB’s 14 policy recommendations to address structural vulnerabilities in the asset management industry published in January 2017, the first eight recommendations pertain to enhancing liquidity risk measurement, management, and disclosures. In the years following the FSB recommendations, regulators around the globe responded with new rules and guidelines, transforming liquidity risk management into a core operational requirement. Most recently, the Canadian Securities Administrators (CSA) published updated liquidity risk management guidance for funds across Canada, and new liquidity stress-testing guidelines for UCITS (Undertakings for the Collective Investment of Transferable Securities), and Alternative Investment Funds (AIFs) went into effect across the EU.

Practical Approach - Overview

Regular monitoring of a portfolio can provide valuable insight and early warnings if there is any danger of not being able to easily meet future redemptions in a timely manner. Having this information readily available could facilitate early discussions with the fund manager to potentially reposition the fund before a redemption occurs.

The ability to monitor the liquidity profile daily using both current market conditions as well as stress scenarios, such as historic events or even customized scenarios, can be invaluable.

A common strategy for liquidating a portfolio is the proportional liquidation method. Here, a manager aims to liquidate an equal fraction of each position in the portfolio. As an example, if a portfolio were required to liquidate 30% of its net asset value (NAV), the manager would aim to liquidate 30% of each position in the portfolio. The advantage of this strategy is in its simplicity and that the remaining portfolio should be similar in structure to how it started before the liquidation.

However, this is not necessarily the optimal approach to liquidating the portfolio. First, this approach is not always possible for a variety of reasons. It may not be possible to divide each asset into small enough parts or there may not be enough liquidity available in the market to sell the less liquid positions. Note that if the most liquid positions in the portfolio are sold to cover the illiquid positions that cannot be sold by proportional amount, the remaining portfolio may end up significantly different with respect to composition, and would be far less liquid in the face of any further liquidations, which would impact any remaining investors in the fund. Second, there is no guarantee that the proportional liquidation method is the cheapest method available as transaction costs are not considered.

One Step Further - Optimization

With this information, however, it is possible to frame this liquidity challenge as an optimization problem. The manager wants to find the cheapest way to liquidate a portion of the portfolio, subject to the liquidity available for each asset in the market, whilst aiming to keep the composition of the portfolio as unchanged as possible.

Consider a hypothetical example where a portfolio (Emerging Europe Equity) has a total NAV of roughly €858 million and the manager is attempting to meet a redemption request of 30% of the NAV within three days. Due to some less-liquid assets in the portfolio, however, using a proportional liquidation method would result in only 26.7% of the NAV being liquidated within three days as some assets take longer than three days to be liquidated by 30%. The manager could decide to cover the remaining 3.3% of the NAV by liquidating some of the larger/more liquid positions in the portfolio (Emerging Europe Equity – Liquidated).

Using the liquidity-adjusted optimization approach gives not only a cheaper execution, but from the charts above, it’s clear that the remaining portfolio (Emerging Europe Equity – Optimized) is almost identical to the original portfolio in terms of its country and sector exposures, and certainly more similar when also compared to the portfolio where the additional 3.3% was covered by liquidating some of the larger/more liquid positions in the portfolio.

It is also possible to go beyond simple weight constraints when running an optimization and incorporate elements such as overall Portfolio Level Days to Liquidate, Absolute Volatility, Expected Tail Loss, etc. This can provide greater flexibility for solving the question of how to execute a redemption without negatively impacting the remaining investors.

Conclusion

Regulations can be viewed as a burden but are generally there to provide safety for investors. Liquidity regulations, however, also provide an opportunity to go beyond just simply meeting these requirements but instead incorporating them as part of the overall portfolio management framework, enabling early warning signals to be detected and any action taken in a timely manner. This is in fact expressly encouraged by most regulators with the U.S. and ESMA requirements even mandating this, but without specific details. By leveraging robust liquidity data sources and quantitative applications, fund managers can truly embrace these regulations whilst also minimizing trading costs.

Ravinder Dosanjh and Nels Ylitalo contributed to this article.