Illiquidity

There is nothing like jumping on a bandwagon to validate one’s internal prejudices, however it must be admitted that some of the criticism of the Woodford fund management process is entirely justified. Firstly, given the mostly rational stance that adherence to long term investment principles is predicated on rising asset values, requiring investors to be “patient”, investing in illiquid securities and giving investors daily liquidity is a classic trilemma – three options, chose two. Secondly, and it feels a bit trite to restate it, but successful fund management is difficult. Whilst individual managers may have real insight into macro-economic conditions or the prospects of certain industry sectors, no-one has deep specific insight into the prospects of a large number of individual and idiosyncratic companies across a wide range of sectors. For this work, large, expensive teams need to be assembled, and their absence is rarely positive. However, I think that the most interesting aspect of this matter is the contingent liquidity risk issue. That is, the fund probably held sufficient stakes in liquid assets to satisfy redemptions, but it could not liquidate assets in a manner that ensured it was consistent with all of its other obligations. As such, bad things, such as gating, happened.
Liquidity risk management typically consists of attempting to determine the cost and the time taken to liquidate the assets of the portfolio. For those in risk management who prefer their work to be more science than art, liquidity risk is the problem child. Firstly, the data is poor, secondly the models are noteworthy for their lack of sophistication and lastly, in extremis, the actual liquidity of anything but the most liquid assets is most likely zero, so no-one will be doing anything, anyway. That does not mean that proper risk management cannot be carried out, it is just difficult. Using objective, market-based risk measures, risk managers can observe the evolving liquidity risk of a portfolio and determine if it is increasing or decreasing as both markets and the portfolio change, and react accordingly.
Contingent liquidity risk is effectively a reverse stress test issue. It is only by modelling the behaviour of a portfolio under stressed liquidation events and considering the subsequent compliance of the portfolio with its various restrictions that potential gating issues can be addressed. Given the attitude of regulators to the gating of retail funds, many Fund Directors, Designated Persons and Conducting Officers may feel the need to carry out such analyses sooner rather than later. With the standard five-year time lag from its introduction in banking regulation, reverse stress testing is currently officially impacting funds via the Money Market Funds Regulation. However, with the rise of Alternative Liquid funds and the associated contingent liquidity risk, there is an argument for applying it more widely across all retail funds.