Why have markets been so alarmed over sudden withdrawals from a handful of European investment funds, like London-based H2O Asset Management? And why did their troubles lead the head of the Bank of England to warn that some funds were “built on lies”? The answer has to do with terms familiar to many in the financial world if arcane to many outsiders: “reach for yield,” “style drift” and “liquidity mismatch.”
1. What do those mean?
For years, mom and pop investors have been pouring their money into mutual funds and exchange-traded products with the promise that they can get their money out anytime they want. At the same time, many bond funds that traditionally focused on investment-grade bonds have been edging into more complex corners of the fixed-income market to eke out returns in today’s low-interest-rate world. That kind of gradual shift is what’s meant by a “style drift.” But many of those higher yielding bonds are in thin or quirky markets, making them potentially hard to trade. The combination of instant withdrawals and assets that can take time to sell is what’s known as a “liquidity mismatch.”
2. Why is that such a problem?
Remember bank runs? Before deposit insurance, they were regular features of financial life because of the liquidity mismatch inherent in banks converting deposits that can be withdrawn at any time into long-term investments. With bond funds, a sudden rush by investors for the exits could create something similar. That’s what Bank of England Governor Mark Carney was referring to when he said that funds holding illiquid assets but promising unlimited withdrawals have been “built on a lie.”
3. What prompted these worries?
In June, one of Britain’s most famous stock pickers, Neil Woodford, froze withdrawals from his flagship equity fund; 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 H2O, which is backed by Natixis SA, has drawn concern, as investments in unrated bonds spurred billions of dollars’ worth of withdrawals in a matter of days.
4. How big a problem is this?
A lot of money falls into this category, though there’s a debate over how acute the dangers are. Carney warned that the risks are “systemic,” with some $30 trillion tied up in difficult-to-trade instruments. U.S. Federal Reserve officials have been warning about potential risks in leveraged loans and CLOs (Collateralized Loan Obligations) since 2013. “Widespread redemptions by investors, in turn, could lead to widespread price pressures,” Fed Chairman Jerome Powell said in May, “which could affect all holders of loans.” Others have pointed to liquidity issues with exchange-traded funds that focus on high yielding loans and with direct lending funds, in which pools of investors make the kinds of loans to mid-sized companies that used to be intermediated by banks. More than 10 trillion euros are managed through UCITS, funds that are governed by EU rules and offer investors regular access to their money even though they can invest in hard-to-trade securities. Both Woodford and H2O used UCITS funds and saw investors pull billions in daily withdrawals.
5. What’s been driving this?
Remember “the reach for yield”? Returns on safe assets plummeted in the 2008 financial crisis and have stayed low ever since. As time has passed, many relatively straightforward U.S. bond funds have increased their holdings of lower-rated bonds, emerging-market debt and other securities, to juice returns. The trend led Morningstar Inc. to change how it classifies U.S. bond funds to make risk levels clearer. In April, it broke intermediate-term bond funds into two categories. Funds in “intermediate core bond” limit exposure to below-investment-grade assets. The second category is “intermediate core-plus bond.” At least eight of the “core plus” funds tracked by Morningstar reduced their allocation to government AAA-rated debt between 2006 and 2018, while allocating more funds to assets rated BBB, the lowest investment grade rating given by Standard & Poor’s.
6. What are regulators doing?
The U.S. Securities and Exchange Commission , which has been concerned about mutual fund liquidity since at least 2015, limits holdings of illiquid securities to 15%. Funds are required to provide a confidential breakdown on the liquidity of their holdings to the regulator, and, as of last month, must also include a discussion on how they manage liquidity risk in annual reports to investors. 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. On the other hand, 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.
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