By Laszlo Hollo, Quantitative Research Vice President at MSCI.
Is there another Woodford waiting to happen?
When the Woodford Equity Income Fund suspended redemptions on 3 June 2019, it showed how, when a fund’s liquidity profile is misaligned with its shareholder profile and redemption constraints, a single large redemption request can trigger gating.
Should institutional investors be worried about liquidity constraints from other open-end funds? Based on our analysis, a handful of large equity UCITS funds had the potential to find themselves in a situation similar to that of the Woodford Equity Income Fund.
Liquidity matters despite less regulation for European funds
The liquidity rules of the US Securities and Exchange Commission (SEC) prevent open-end mutual funds from holding more than 15% of their investments in illiquid assets, with the aim of reducing the likelihood of redemption suspensions. While the corresponding European regulation does not set limits on holdings, funds complying with the rules must allow redemptions at least twice a month — and many UCITS funds permit withdrawals on any day, known as daily dealing.
This may create an incentive for a UCITS fund to hold sufficiently liquid investments to ensure alignment with daily dealing — or whatever has been promised in terms of withdrawal rights. As Andrew Bailey, Chief Executive Officer of the UK Financial Conduct Authority put it: “It is not sensible to provide for daily dealing and redemption in open-ended funds that hold a large exposure to illiquid assets, including those that while listed are not regularly traded.”
How do other funds’ liquidity profiles compare to Woodford’s?
We used MSCI’s LiquidityMetrics to assess the liquidity of a sample of European funds with similar characteristics to Woodford’s, analyzing UCITS funds with assets under management greater than €1 billion that primarily invest in equities. We applied the SEC bucketing rule to study how each fund’s liquidity profile would look if the US regulation applied. In the exhibit below, we ordered about 400 such UCITS funds along their highly liquid bucket proportion under a 5% anticipated trading scenario.
Most, though not all, UCITS funds were highly liquid
Source: MSCI.
The vast majority of these portfolios were very liquid. However, there were a handful of funds that warranted further examination. In the exhibit below, we compare the liquidity profile of the 15 least liquid UCITS funds, ranked by their highly liquid fraction, to that of the Woodford Equity Income Fund’s 85% illiquid holdings, as of 31 December 2018.
Seven of the funds breached the SEC’s 15% illiquid-holding limit, and approximately 1% of them had less than half of their holdings in the highly liquid category. In short, the liquidity profile of these funds may be misaligned with anticipated redemption requests.
Least liquid UCITS compared to Woodford Equity Income Fund
Source: MSCI.
The price of misaligned liquidity
Misaligned liquidity can be a risk for both institutional investors and fund managers. For institutional investors, a potential liquidity mismatch may prevent them from withdrawing their capital upon request, while the suspension of withdrawals may harm a fund manager’s reputation. Even though most of the analyzed UCITS funds seemed sufficiently liquid, there was a handful with relatively large exposure to liquidity risk. The Woodford fund highlighted the importance of keeping an eye on a fund’s liquidity profile as a key component of managing risk.
The author thanks Laszlo Arany, Quantitative Researcher at MSCI for his contributions to this blog post.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)