Pedestrians cast shadows as they round a corner next to the Bank of England (BOE) in the City of London, U.K., on Thursday, Feb. 7, 2019. The BOE warned that damage to the economy from Brexit has increased as it cut its growth forecast and predicted a dramatic slump in investment. (Bloomberg)

“You can’t always get what you want,” the Rolling Stones sang. The band didn’t have illiquid assets in mind, but investors who put their money into funds that put it into things that can be hard to sell in a hurry would certainly agree, as was shown by recent market turmoil. Bank of England Governor Mark Carney said funds that hold illiquid assets but allow unlimited withdrawals have been “built on a lie.” Carney warned that the risks are “systemic,” with some $30 trillion tied up in difficult-to-trade instruments. A lot of that money is in mutual funds and exchange-traded products owned by mom and pop investors, raising questions of who’s responsible for keeping investors safe from having liquidity dry up at just the wrong time.

1. What’s happened?

In June, managers froze withdrawals from a fund run by Neil Woodford, one of Britain’s most famous stock pickers; that followed a move to block massive outflows at Swiss asset manager GAM Holding AG, where star bond manager Tim Haywood was dismissed in February. Now a global macro fund run by London-based H2O Asset Management is facing the equivalent of a run on the bank.

2. Who’s responsible for overseeing funds?

It depends on where you are. The U.S. Securities and Exchange Commission authorizes and regulates publicly traded funds under the Investment Company Act of 1940. Funds in Europe are governed by each country’s regulators. In the U.K., the Financial Conduct Authority oversees asset managers and funds. Most funds in the Europe Union, like H2O’s, are highly regulated UCITS, an acronym for Undertakings for the Collective Investment in Transferable Securities that goes back to a 1985 directive. They can be sold across the region and have grown to manage more than 10 trillion euros, according to the European Fund and Asset Management Association.

3. How do UCITS funds work?

The EU has set rules on funds’ liquidity requirements, risk limits, transparency and leverage. They can use derivatives to create some leverage and short exposure, but not as much as traditional hedge funds. Trading certain assets such as commodities is restricted. While the original 1985 directive set broad rules, each country has flexibility in adopting them.

4. How is their liquidity regulated?

For UCITS, liquidity risk is limited by the “5-10-40” diversification rule. It restricts a funds holdings to 5% in securities issued by the same body. But that limit can be raised to 10% as long as the total value of the securities in which it exceeds the 5% threshold totals less than 40% of the fund’s assets. Mutual funds in the U.K. are allowed no more than 10% of their assets in unquoted securities, a limit that Woodford’s now-frozen fund breached twice, according to the Financial Conduct Authority.

5. How about in the U.S.?

U.S. government agencies have compliance rules, but they often rely on voluntary reporting or external sources to bring problems to light. The SEC stiffened liquidity requirements in a 2016 rule that requires funds to “confidentially notify the Commission” when illiquid investments exceed 15% of assets. The SEC declined to comment on the rule’s impact or disclose the number of funds that have filed notifications since the rule was imposed. The funds are required to publicly report their holdings within 60 days of the end of each quarter.

6. Who else watches funds?

Morningstar Inc., CFRA Research and Lipper, a unit of Blackstone Group LP’s Refinitiv, are among non-government providers of independent ratings and recommendations of funds. In the U.K., fund platforms such as Hargreaves Lansdown Plc also track funds and are widely used by investors as a guide. It was a June 19 Morningstar note putting the H2O Allegro fund “under review” that sparked more than $7 billion in outflows, while Hargreaves Lansdown faced questions on its recommendations for Woodford funds. Hargreaves subsequently removed two Woodford funds it had from its Wealth 50 list of favorites.

7. What do they look at?

Factors including fund performance, fees and expenses, holdings, manager tenure and the quality of the fund’s parent firm. Morningstar, for example, labels funds with up to five stars based exclusively on data. It also awards Gold, Silver and Bronze medals to funds based on deeper research, including visits to trading floors and interviews with fund managers. H2O Allegro was downgraded June 27 to neutral from bronze. For equity funds, analysts look at factors of holdings such as market capitalization, trading volume and diversification or concentration of risk. For bond funds, key factors include credit quality and interest-rate risk, also known as duration.

8. What about liquidity?

Those analyst assessments often don’t directly capture whether holdings are illiquid, which the SEC defines as an asset that cannot be sold within seven days at approximately the price it’s valued. Illiquid assets can often yield higher returns -- until they don’t. And even if they’re a minor slice of a portfolio, they can trigger problems when markets go south. “One of the things we’ve found is that a small exposure to an illiquid instrument can become a bigger issue” if outflows surge, Jeffrey Ptak, global director of manager research for Morningstar, said in an interview.

9. How common is a fund freeze?

At the height of the financial crisis, many hedge funds resorted to gating funds as they scrambled to avoid asset fire sales. But stopping investors from taking their money out is rare in daily dealing funds. The U.S., the largest market for mutual funds, has permitted only six of them to suspend redemptions since 1972, according to the Investment Company Institute. What has alarmed investors in Europe is the rising frequency of the problems surrounding these funds now.

10. What’s the broader concern?

Potentially risky assets include leveraged loans -- loans to businesses with less than stellar credit -- which have expanded to a $1.2 trillion market. The yield-hungry investors who poured money into the assets, may not find it easy to get everything out. “Widespread redemptions by investors, in turn, could lead to widespread price pressures,” Federal Reserve Chairman Jerome Powell said in May, “which could affect all holders of loans.” While Carney and others warn of potential systemic problems, the number of funds that have closed and blocked redemptions is relatively small compared with the hundreds of U.S. funds that close annually because of shrinking assets or investment losses.

11. What types of funds might be vulnerable?

There was a lot of concern that fast-growing ETFs would run into trouble, but market turmoil in the fourth quarter of last year showed their resiliency, according to Todd Rosenbluth, director of research for CFRA. Investors lost a lot of money on exchange-traded notes that bet against high market volatility, such as the VelocityShares Daily 2x VIX Short Term ETN, he said, but withdrawals weren’t restricted (or gated, as that’s sometimes called). The bigger risk comes from active managers who seek to beat indexes by deviating from benchmarks and straying into higher-yielding holdings, sometimes referred to as style drift. “Many active managers are trying to highlight how they’re different than the benchmark, that they’re worthy of the premium price they charge,” Rosenbluth said. “To be different from the benchmark, you’re going to have to search for hidden gem opportunities and in many cases, what you end up with, is a lump of coal.”

To contact the reporters on this story: John Gittelsohn in Los Angeles at johngitt@bloomberg.net;Nishant Kumar in London at nkumar173@bloomberg.net

To contact the editors responsible for this story: Alan Mirabella at amirabella@bloomberg.net, John O’Neil

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