Veritas – How illiquidity rings the early alarm bells

Liquidity, or the lack of it, is one of the most important early warning signals asset managers look for in their business – and with very good reason.

When BNP Paribas announced on 8 August 2007 it had suspended redemptions from three ABS funds after trading on US sub-prime “suddenly dried up regardless of the quality of assets”, alarm bells rang in the industry.

It did not matter those funds had only 35% of assets, or €2bn, in US sub-prime all rated AAA or AA. It did not matter the funds represented less than 0.001% of BNP Paribas Investment Partners’ assets under management. And it did not matter all the funds reopened within three weeks, down 2% or less.

What mattered was liquidity had evaporated and worse could – and did – come.

The danger of illiquidity to funds has emerged again, as UK watchdog the Financial Services Authority confirmed last week it is asking asset managers to supply the results of stress tests on their domestic corporate bond funds.

It also requires data on internal liquidity, and on how long it would take managers to meet any potential redemptions.

Data on the Sterling Corporate Bond unit trust sector from FE shows only five of 29 portfolios have more assets now than they did one year ago. In one case, assets are 92%, or £1.14bn, lower now.

Having to sell that volume into an illiquid market would hurt – and managers have hopefully recognised this in their portfolio construction.

Those running open-ended property funds in Germany have undergone their own mini ‘liquidity crunch’ this year. Many suspended redemptions as they could not sell enough properties quickly enough to meet withdrawal requests.

Sometimes trouble hits so quickly, managers have no chance to plan an orderly disposal of assets. One prominent US hedge fund manager speaking in London recently said his boss demanded he offload assets to provide $1.5bn cash, quickly, near the height of the financial / liquidity crisis of 2008/2009.

Analysis of the hedge fund industry by eVestment/ shows that these days, 90% of portfolios would be completely drained by such a request – although fund managers with more than one sub-$1.5bn fund could feasibly still survive it.

There is no suggestion, of course, that what happened in 2008/2009 to US sub-prime is about to happen to managers now being affected by partial market illiquidity in the UK or in Germany.

But the events now, and in 2007, are timely reminders to allocators to check the liquidity profile of their chosen funds, and for managers to monitor how deep their market really is.

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