A decade on and the risks associated with overexposure to illiquid assets are once again at the forefront of investor concerns, following a series of high-profile liquidity squeezes at various fund groups this year.
Sound the alarm
British fund manager Neil Woodford ceased withdrawals from his €4.1bn flagship fund, Woodford Equity Income, in June after it racked up huge losses amid excessive exposure to illiquid assets; and last year, Gam Investments liquidated its €9.5bn absolute return range amid similar concerns.
During the summer, Natixis affiliate H2O Asset Management suffered multi-billion euro outflows from its corporate bond funds after liquidity worries, related to illiquid bonds issued by a controversial German financier with a history of bankruptcies, were reported in the media.
A European fund selector was among those who disinvested from H2O following the reports. “We had a call with H2O to ask them about the measures they had taken to reduce liquidity risk and decided to reduce our position,” the fund selector told Expert Investor on condition of anonymity.
H2O blamed “unfair” media coverage for the outflows, which ultimately amounted to 30% of assets at its biggest fund Adagio, before the French fund group stabilised the situation.
In July, global index provider MSCI warned that seven large Ucits equity funds could struggle to meet redemptions due to high levels of illiquid stocks in their portfolios.
“Woodford, Gam and H2O will not be the last fund groups with liquidity issues,” warns the anonymous fund selector. “It was only because of media coverage that investors became concerned about H2O.”
All of the positions in H2O’s funds had been published in their annual reports, including the bonds issued by the German financer. But few fund selectors had apparently read these reports prior to their being alerted by the media to the illiquid positions.
David Karni, head of portfolio management at BCC Risparmio & Previdenza in Milan, says fund selectors need to pay more attention to the underlying holdings of the funds they invest in.
“We should be more aware of a fund’s illiquid positions,” says Karni, adding that selectors can sometimes focus too much on the investment process when undertaking their analysis. “We need to do more thorough due diligence, for example checking whether a fund manager has instruments to quickly navigate liquidity issues.”
It’s a lesson Karni admits he learnt from the problems at Gam and H2O. “We used to have positions in some of the funds that had liquidity issues, such as Gam’s absolute return fund. It was on our recommendation list on the advisory side. But we sold our positions before they got into trouble.”
Karni adds that BCC Risparmio & Previdenza now prefers to invest in directional funds due to the more transparent risk profile of these funds. “We continue to use some flexible bond funds but only in a marginal way,” he says. “They are not a core part of our portfolios anymore.”
The question remains, however, why so many investors apparently do not strictly monitor the portfolios of the funds they invest in. This was evidenced by the surge in outflows after illiquid holdings, which were already publicly available, were highlighted in the media.
“Fund selectors, including myself, have put too much trust in fund managers in the past, believing they would manage liquidity risk appropriately and in the interest of their clients,” says Karni, adding that recent events have made him more vigilant.
“We prefer to avoid working with managers who are not transparent. If a manager doesn’t publish their portfolio, I tend to believe they have something to hide. “We now insist on seeing the complete portfolio of all funds we invest in on a monthly basis. This morning, I sent an email to an asset manager who hadn’t sent us a portfolio update for two months. I expect to send more emails like this in future.”
Stars in their eyes
It’s no coincidence that all the funds which have experienced liquidity issues during the past year have been flexible ‘go-anywhere’ funds run by high-profile managers, according to Bart van de Ven of Accuro Wealth Advisors, a Belgian wealth manager.
“I’ve become more hesitant to invest in funds run by star managers who decide everything,” he says. “All managers need the support of critical analysts to ensure proper risk management and avoid complacency.”
Boutique-style funds led by star managers that have grown quickly are particularly risky, he adds, pointing out that Gam’s absolute return fund, Woodford’s equity income fund and the H2O corporate bond funds all became very large, very quickly following a surge of investment over a short time period.
H2O’s AUM, for example, increased tenfold from 2013 to 2019, to €30bn.
“Larger funds are more likely to invest in less-liquid bonds and can have more problems disposing of the investment. The percentage of liquid assets in the portfolio may be small but the absolute amounts can be substantial,” he says.
“The sheer size of the H2O corporate bond funds – €17.2bn before the outflows – is the only reason they got into trouble. Having 5% of your assets in illiquid bonds is normally fine.
“But because H2O’s bond funds had grown so big, the absolute amount became a problem,” the anonymous European fund selector highlights.
“A fund’s size and the speed it is growing will play a bigger role in its selection process in the future,” the fund selector cautions.
Funds run by high-profile managers also typically account for the bulk of a fund group’s income, which is also an issue, says Karni. “Fund groups typically heavily promote
star managers to try and get as much money as possible – but that is not necessarily in the interest of existing investors.”
Another potential red flag can be when fund managers own their own funds, adds Karni. “We like it if a fund manager has a stake in their fund but it’s important to strike the right balance.”
“If the fund manager is also the owner of the fund group and receives fee income directly, it can be an incentive to raise as much money as possible over a short-term period.
“We prefer incentives to be more aligned with those of investors, such as tying remuneration to three- or five-year performance,” Karni explains, noting that such remuneration models are not particularly viable at small fund manager-owned boutiques.