The perils of fund liquidity
I’ve noted here, several times, the perils of fund liquidity. The Woodford Equity Income Fund is just the latest manifestation of something we’ve seen several times before. The end result is not pretty:
Investors who poured money into the failed Woodford Equity Income fund face claiming back as little as £338 for every £1,000 they put in, according to official estimates.
As I say, we’ve seen this before in property funds, in bond funds and it’s obviously the basic problem with fractional reserve banking as well. A mismatch between the liquidity on offer from the provider and the liquidity available in the underlying investment. Or, if you prefer, we can talk about time horizon mismatches. It comes to the same thing.
The lesson here being don’t invest in open ended funds unless the fund itself is in something highly liquid. Or at least know the risks you’re taking.
If you’re a bank you borrow short and lend long. According to Brad Delong at least, that’s the definition of banking. Depositors can – usually, and often enough for us to take this as being wholly true – get their money back whenever they like simply by asking. But loans out are going to be for longer periods. Our deposits might be at sight, but that loan out as a mortgage is for 30 years.
This obviously causes possibilities for banks to get caught out. More people turn up for their deposits back than they expected, exhaust the small amount of cash held in the vaults, and the bank goes bust. If it had time it could get all the money back from those loans. But it doesn’t have the time, therefore cannot gain the cash to pay out. We know this is a problem, that’s one of the reasons the Federal Reserve exists. To provide liquidity to a sound bank that is suffering a bank run.
Open ended funds
An open ended investment fund can suffer from the same problem. As I say, I’ve highlighted this before. One example was a commercial property fund or three in the UK. Some people decided they’d like their money back which is fair enough, the terms are that they could. But it’s an open ended fund, meaning they didn’t just sell their stock to someone else. Rather, it had to be the fund itself that liquidated some investment and thus raised the money to pay off investors. Sure, there was some percentage point or two of cash just in case some wanted to do this. But when proposed redemptions rise to 3 or 5 or 10% of the fund then actual whole buildings must be sold. And that takes some time.
The investors were promised they could leave in a day, say, but selling a building takes 6 months. That’s a significant liquidity mismatch.
Much the same happened to a couple of corporate bond funds. The government bonds markets are some of the most liquid in the world. Corporate bonds not so much. Outside the truly large companies most corporate bonds get traded just the once in their lives. Issued, traded into a fund then redeemed some years later.
So, when some such funds got hit with a wave of redemptions they too suffered from that liquidity mismatch. They couldn’t sell assets fast enough to pay off leaving investors.
The Woodford Equity Income Fund was in stocks, given the name. It also had a spread of liquidity in its holdings. But it was much more illiquid than the offer to investors. They were to be able to trade out of the fund as they wished. Then too many of them desired to do so.
At first the more liquid equity holdings were liquidated to allow them to do so. But this rapidly ran onto the rocks of that great illiquidity as the portfolio was reduced.
So, what happens then?
Once the illiquidity event has taken place there’s really little possible other than to suspend redemptions from the fund. That is, investors have to be denied the very thing they’re using a fund for, liquidity. This happened to the real estate, bond and then Woodford funds. What’s making the recovery rate at the Woodford fund so appalling is that now there’s only that highly illiquid rump left and that has to be liquidated in the short to medium term. Some of those plays are, however, rather long term, so getting out of those positions quickly is going to be value destroying.
There’s a lesson from this, be very wary of open ended funds and their liquidity.
The Fed and stablecoins
The Federal Reserve has declared itself worried about stablecoins. On very much this liquidity basis:
A global stablecoin network, if poorly designed and unregulated, could pose risks to financial stability. The failure of a stablecoin to operate as expected could disrupt other parts of the financial system. For example, the inability to convert stablecoins into domestic currency on demand or to settle payments on time could create credit and liquidity dislocations in the economy. If a stablecoin’s credit, liquidity, market, and operational risks are managed ineffectively, it could face a loss of confidence. This loss of confidence could lead to a run, where many holders attempt to liquidate their stablecoins at the same time. In an extreme scenario, holders may be unable to do so, with potentially severe consequences for domestic or international economic activity, asset prices, or financial stability.
They’re worrying about exactly the same thing. A liquidity mismatch. If the market for the underlying asset is less liquid than the offer being made to the stablecoin holders then a run is a possibility.
Assuming that stablecoins are based upon rational baskets of fiat currencies I don’t see this as a problem. The FX markets are perhaps the only ones on the planet even more liquid than government bond ones. But it’s obviously possible if coins are based on less liquid assets. It would be bizarre if they were but then in the crypto space you never know what someone’s going to do next.
Given the attention we give to liquidity mismatches in the banking system – we’ve been having bank runs for centuries now and we invented central banks to deal with them – I’m surprised that it’s taken so long to address exactly the same problem in open ended funds. For the structural problems are exactly the same. If a run starts then it’s near impossible to halt and we don’t have any central bank back up for such funds.
The investor view
There are merits to open ended funds just as there are to closed end ones. In this specific instance, over this issue, the closed end fund has the advantage of simply not being able to suffer from a liquidity mismatch. If someone wants out they simply sell their units to another, the fund doesn’t have to redeem.
As investors this means that we’ve got to be careful about which sort of fund we use ourselves. My recommendation is only to use open ended funds when the underlying investment is as liquid, at least, as that liquidity on offer to us as fund investors.
So, a private equity fund operating on a 5 year horizon is fine as long as we’re being locked in for that 5 years. A VC fund for a decade equally just fine.
An open ended fund offering daily redemption? If the underlying is government bonds then yes, why not? Or even if it’s an equity fund only holding FTSE350 stocks, or S&P 500, or Wilshire 5000 perhaps.
The same goes for ETFs in near everything. The underlying liquidity should match what is on offer to us. Not as an absolute rule, but we must at least be aware that when the fecal matter hits the spinning object being in a fund that doesn’t meet this can mean a loss of our own liquidity. And, obviously, value, if the portfolio has to be liquidated in a fire sale.
As to the Fed and stablecoins I think they’re worrying unduly but then seriously, who does know what someone’s going to propose next over there? Err, in crypto, obviously, the Fed’s not that bad these days.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.