Drying Up

It would be logical to think that investors could take a read from the strength of global markets in 2019 as an indication that things were set fair for a smooth run on fundamental factors into the start of 2020.  The volatility seen in the first few weeks of this year has reminded us yet again that looking backwards can only take us so far in the investment game, and “unknowables” will always be a factor in what happens going forward.  As we stand today, we can only guess at the likely impact the outbreak of Coronavirus will have on global economic growth, and by extension on the earnings earning capacity of quoted businesses worldwide.  What we do know is that no-one was highlighting a potential pandemic as a key stock market risk a month ago.

However, developing risks needn’t necessarily come from left field.  Many can build up over years or even decades, with hindsight after the event showing indeed that the warning signs were there for those willing to see them.  The low capital ratios in the banking system and the multi-layering of risk in the CLO/CDO markets that created so much of the devastation associated with the great financial crash were all out in the open in the years before the crisis began.  Similarly, the weaknesses in Southern European government finances in the years leading up to the Euro Zone debt crisis were hidden in plain sight.  In these instances, it is the suspension of disbelief that exacerbates the scale of the problem, because it is easier than addressing it head on.

Our last “Wise Man” strategy meeting in December highlighted another potential issue building in the financial system that can hardly be said to be hidden from anyone willing to look for it.  In October, the IMF released a report on the impact sustained low interest rates were having on liquidity risk building in the fixed income market.  A crucial element of 2019’s stellar investment returns was the general loosening of monetary policy, with interest rate cuts in the United States and China, and the restart of QE in the Euro Zone.  Across the globe, bond yields dived across the maturity spectrum, further putting pressure on those with fixed liabilities in the future (such as pension funds) to find assets that can suitably match such obligations.

The IMF report makes a few important observations:

Pension funds and life funds have significantly increased their allocations to alternative assets (private equity, infrastructure assets etc.).  These investments frequently come with contingent funding obligations that will sap these funds of cash and liquidity when they might need it most.  This category of investor has traditionally acted as a natural stabilizer in times of market stress, but these funds may not have sufficient liquidity to perform that role when the next downturn hits.

Fixed income funds have become more homogeneous, with increased conformity of the risks taken across the sector.  The IMF notes that this increases the risk of faster transmission of panic across the sector as everyone tries to sell the same assets.

Related to the previous point, duration risk has increased across the spectrum of fixed income funds, making the sector more sensitive to interest rate moves.

Liquidity risks across the sector have increased.  The IMF estimates that in stressed conditions up to 15% of investment grade fixed interest funds will struggle to meet liquidity needs.  This increases to almost 50% of funds when looking at the high-yield sub-sector.

It is important to stress that the IMF is not questioning the value or validity of the underlying assets; the question raised is one of liquidity.  However, it is equally worth noting that in retrospect the 2008/9 crisis was also one of liquidity.  Whilst banks had too little capital, arguably their balance sheets were solvent; it was the reliance on short term wholesale funding that caused them to go cap in hand to their respective governments for bailouts.  Similarly, with the exception of Greece, the governments caught in the teeth of the Euro Zone debt crisis would not have been anywhere near as badly affected had they been able to control their own monetary policy and debt management obligations.

Liquidity in regulated funds in the UK and Europe (such as UCITS vehicles) is an ultra-hot topic for regulators at the moment.  A recent “Dear CEO” letter from the FCA to asset management firms made it clear that supervision of regulated fund liquidity would be an absolute priority in the post-Woodford landscape.  Ensuring that daily traded funds have sufficient liquidity to meet all possible redemption requests is a cornerstone of the UCITS regime, but it highlights the inherent conflict at the heart of many fund investors’ aspirations.  Those investors willing to pay a premium for active investment expect to get genuinely differentiated fund offerings; and in many areas that means taking stakes in smaller-sized and less well researched assets.  However, many of those same investors demand the ability to move up to tens of millions of pounds of investment on a daily basis into these same funds.

Over recent years, the default position to resolve this conflict has been that bigger is always better.  Bigger funds taking bigger stakes in smaller entities.  This is perfectly sensible, until everyone wants their money back.  Then, the position becomes unmanageable and not only is liquidity compromised, but value is also destroyed as strategic stakes are offloaded onto unreceptive markets.

It is likely that investment trends will evolve to target “sweet spots” where funds are small enough to be genuinely active, but large enough to accommodate most investment flows.  It will also require a more partnership based approach between fund managers and their larger investors.  Fund managers will increasingly disclose the true liquidity characteristics of their funds; the largest investors will need to work with smaller houses to build funds to commercially appropriate scale.

We have always been acutely aware of needing to strike the correct balance been differentiation and liquidity.  With a focused portfolio of 25 stocks, the proposition is genuinely unique.  At the same time, all holdings are fully quoted, and 95% of the portfolio is in companies where we own less that 1% of the available free float.  We have the capacity and capability to comfortably deal with flows in either direction in the tens of millions of pounds.

Increased regulatory and investor focus on liquidity will be beneficial for our industry over the medium and long term.  It is likely to challenge head on the suspension of disbelief that placing illiquid assets in a liquid wrapper makes them in some way more liquid.  Investors will be more accepting that certain asset types need to go in closed-ended funds, or funds with longer redemption notice periods.  Ultimately, that will lead to less panic when the market faces its next crisis.