This is precisely one of the ways in which UCITS funds are defined: they have the obligation to redeem fund units at any time, i.e. they must be liquid at all times. Suspension of this obligation is allowable only by way of exception. Such a situation is bound to result in a loss of confidence on the part of the investor.
These events have increased the need to monitor the liquidity of funds. In reaction to these events, regulatory measures have also been introduced at European level. The UCITS IV Directive passed on 13th July 2009 for the first time contains the requirement to monitor the liquidity of funds. The forthcoming AIFM Directive will make it obligatory to monitor the liquidity not only of UCITS funds, but also of all investment funds that are not in conformity with the UCITS Directive (Article 16 Liquidity management, AIFM Directive). In Germany, InvMaRisk (minimum risk management requirements for investment companies) lays out detailed requirements with respect to liquidity management.
A complicating factor is that regulators haven’t issued specific guidelines about the manner in which liquidity is measured and the extent to which liquidity for a fund or fund type must be maintained. This raises two questions:
How is portfolio liquidity measured?
Liquidity is a term that does not lend itself to being formalised. The methods used to monitor liquidity within the meaning of the UCITS Directive are therefore based not on statistical but on empirical methods. On the basis of empirical values, asset classes are grouped with respect to their liquidity. Thus, cash at bank is by definition liquid. Government bonds as well as shares listed on European markets are considered to be highly liquid, corporate bonds as less liquid, etc. Over-the-counter derivatives are illiquid. In order to evaluate individual securities, information such as trading volumes or the bid/ask spread is assessed.
In addition to the characteristic of an asset class or an asset with respect to the market demand, the settlement characteristics must also be considered when evaluating liquidity. Real estate is by its very nature less liquid than a share because ‘settlement’ takes considerably longer. Furthermore, it must be understood that the sale of large asset positions within a short period could influence both demand and pricing. All of these factors affect the measurement of liquidity on the asset side and the available liquidity of a fund.
How much liquidity is necessary?
On the liabilities side, the degree of liquidity required of a fund due to cash outflows must be further differentiated. There is a structural distinction between the liquidity requirements placed on retail funds and those placed on institutional funds. In the case of an institutional fund, there are as a rule fewer investors with information known about them. The fund manager often has information about the cash outflows to be expected and the amount. In general, there is usually sufficient information about the short-, medium- and long-term need for liquidity. With retail funds there are larger numbers of mainly small investors. Neither the investors themselves nor their intentions are known to the fund administrators. For this reason, the liabilities side is an unknown that can only be estimated using both empirical and statistical methods.
For each fund a liquidity ratio is often determined (example: 25% NAV). This ratio is determined on the basis of empirical values for the individual fund. Likewise, the cash outflows determined for specific fund types (example: equity funds) over previous years are evaluated to provide the liquidity requirement for that specific fund type. However, this is only possible if the corresponding data sources are available. Recently in Germany, methods from Extreme Value Theory are under discussion as a means of predicting cash outflows. However, currently there is no standardised solution.
Practice-driven solutions
In day-to-day practice, monitoring the liquidity of funds presents both a factual as well as technical challenge. A company may have to monitor hundreds or even thousands of funds daily. Whereas many fund administrators use in-house Excel solutions, Princeton Financial Systems (PFS) has developed its own standardised method for MIG21, its investment compliance and risk monitoring solution. The system enables all funds to be monitored at a glance and be analysed by drilling down to each fund individually (i.e. liquidity monitoring at asset level). As a supporting function, there is a range of reports available (e.g. time series of a fund’s liquidity). Additionally, MIG21 is a reliable system with standard features such as historisation of data, guaranteeing of audit compliance, auditing of user actions, which can also be used to monitor liquidity.
The LawCard module ‘Liquidity Risk’ covers two methods: the BVI method and the term method.
The BVI method was developed by risk managers under the patronage of the German Association for Investment and Asset Management (BVI).
With this method, criteria for the different asset classes are specified (example: listed shares are liquid). Additionally, for specific asset classes an upper limit (cap) is set as a percentage of the NAV beyond which a particular asset class is not taken into account for the calculation of the liquidity ratio. Individual assets may – due to special market circumstances – be characterised as having limited liquidity. Each of these assets has its own cap beyond which they are not taken into account for the calculation of the liquidity ratio. The total liquidity of the individual asset classes, where applicable capped by the relevant liquidity upper limits, then results in the liquidity ratio. When checking the rule, the liquidity ratio of the fund is compared to the minimum liquidity for the relevant fund type relative to the NAV of the fund.
The term method was defined by PFS on the basis of discussions with market participants. This method brings to the fore the following questions:
• How much liquidity can be provided short-term (up to four days)?
• How much liquidity can be provided medium-term (up to ten days)?
• How long would complete liquidation of the fund take?
Using this method, the liquidity of the assets is evaluated according to different criteria: asset class (shares, bonds, fund units, derivatives, cash at bank etc), issuer (state, company), rating, maturity, settlement period, etc. On the basis of these criteria, the assets are grouped according to short-, medium- and long-term liquidity as well as illiquidity. Each group is checked against a fund specific threshold (example: short-term liquidity >= 10% NAV). Individual assets may – due to special market circumstances – be categorised as having short-, medium- or long-term liquidity or illiquidity.
Both solutions are flexible with respect to the standard setup and can be adjusted to each customer’s requirements. Questions regarding the definition of ‘short-term liquidity’ covering a period up to four days or the relative liquidity of corporate bonds compared to covered bonds are left to the discretion of the individual customer. Both methods are used in parallel for all funds.
This standard solution applies only to the asset side, i.e. it calculates the amount of available liquidity in the fund. With respect to required liquidity, the system depends on external parameters. As yet, there is no standardised method for estimating the liquidity requirement of a fund. In Germany, the BVI in conjunction with industry representatives is looking into various solutions for the liabilities side. It remains to be seen if a suitable solution will emerge.
