Ejector seats of investment: Harnessing liquidity risk management to avoid financial freefall

In 1944, Douglas Davie, a test pilot with the Royal Aircraft Establishment (RAE), UK, was flying the prototype of Gloster's twin-engine jet fighter, the Meteor, when one engine completely disintegrated. As he tried to bail out, Davie's left arm was severed, possibly due to the canopy snapping shut in the windblast. Astonishingly, he still managed to get out, only to be critically injured by the aircraft's tailplane as he tried to leap clear. Unable to open his parachute he plummeted to the ground.

The Davie accident appalled the Air Ministry, which had seen too many combat crews lost in this way and prompted it to seek a way for pilots to escape from jets. It was a move which helped create the explosively fired, rocket-assisted ejector seats that have saved thousands of aircrews lives since the dawn of the jet age. Liquidity risk management is the investment funds’ ejector seat.

Liquidity risk is one of the most harmful, yet least emphasized investment risks. It is the risk when an investment fund is unable to meet funding requests in a timely manner without significant negative impacts on the fund’s net asset value. These funding requests could be investor redemption requests or creditor margin loans.

Liquidity risk is highly pernicious. In its mildest forms, investors experience unnoticed, yet very real losses as funds forced selling reduces realised sale price. In its more extreme forms, funds are forced to temporarily freeze redemptions, limiting investors’ ability to access their money, normally while the value of their investments decline. In its most extreme cases liquidity risk results in investors not being able to temporarily redeem their investments and can result in them losing their entire investment. There are regular examples of these extreme outcomes, meaning investors should question a fund’s liquidity risks when making their investment decisions.

The most common source of liquidity risk is a timing mismatch between investors’ (prescribed) access to funds and the ability for a fund to sell investments. For example, a fund that offers unitholders daily liquidity but invests in highly illiquid assets (e.g. unlisted property or unlisted companies) may not be able to readily dispose of assets to fund redemption requests. This could force the fund into a fire sale, resulting in suboptimal selling prices.

One of the issues with managing this timing mismatch is that it is difficult to predict as they are often predicated on investor psychology. Severe liquidity risk outcomes require a mass of investors to simultaneously seek to redeem their investments. Identifying the catalyzing events for these redemptions is not always obvious.

Figure 1 offers examples of investment funds where liquidity risk resulted in the fund either having to suspend redemptions or failed entirely. A key observation of the table is the variety of catalysts for the liquidity related losses. LTCM and CCC were victims of a brief cataclysmic event resulting in temporary price declines. Third Avenue Management’s issues followed an approximate one year of underperformance, while Woodford Capital’s initial redemptions followed a handful of years of underperformance coupled with a panic when the market realised, he couldn’t fund all the redemptions owing to the fund holding large illiquid positions.

Redemption requests don’t always follow periods of poor performance. The primary driver of GAM mass redemptions resulting in GAM freezing funds in its Absolute Return Bond funds, was the dismissal of one its star traders. Six of H20 Asset Management’s funds experience significant outflows following a FT report that it held illiquid bonds related to a controversial investor, Lars Windorst. Columbia Threadneedle’s redemptions followed several of its largest investors redeeming their investments from that fund to cover their own liquidity issues stemming from the Truss government’s disastrous mini budget.

Figure 1 - Examples of high-profile funds that experienced liquidity-related problems

Source - Pella Funds Management

Across all the issues faced above we believe only Woodford Capital is an example of liquidity crisis that was entirely foreseeable. In the other examples it can be argued that it was virtually impossible to know ahead of time what would catalyze huge redemptions. Sometimes it is a large one-off event such as Russian debt default, or a broad systemic credit event. At other times it is an internal governance issue (GAM), investor reaction to controversial investment (H20), or simply that a handful of large investors face their own liquidity issues (Columbia Threadneedle). Nonetheless, sub-optimal risk management played a critical role in all the examples presented.

The whole point of risk management is to control threats to the fund’s investment performance. The fact that the catalyst for liquidity risks is not always identifiable ahead of time does not mean those risks can't be managed.

Pella’s approach to managing those risks comprises of three primary pillars:

The first pillar is the type of company we invest in. Pella applies market capitalization and liquidity requirements to our investments. Our minimum market capitalization is US$1.5b, and we primarily invest in companies that enable us to enter or exit our target position within five trading days at 20% of the daily volume traded.

The second pillar is how we construct the portfolio and avoid having oversized exposure to any one company. This means we cap fund exposure to 5% of any of the company’s share capital and the maximum weight of a position (at cost) is 5% of the fund value. Combining those two risk avoidance measures, Pella targets the ability to exit 67% (two-thirds) of the portfolio within five trading days at 20% of the stock’s daily trading volume assuming the portfolio is at its capacity of US$10 billion AUM.

The final pillar is how we manage our business. Pella actively seeks a diversified investor base. This strategy means the redemption decision of any one investor is unlikely to impact the liquidity of the broader fund.

In conclusion, the importance of effectively managing liquidity risk cannot be overstated. The examples presented in this blog illustrate the devastating effects of poor liquidity management from forced asset sales at reduced prices to complete fund collapses. These instances underscore the unpredictable nature of liquidity-triggering events and the catastrophic impact they can have when funds are not properly prepared.

Pella Funds Management's approach, focusing on investment selection, portfolio management, and maintaining a diversified investor base, demonstrates a proactive strategy to effectively mitigate these risks. By limiting exposure to illiquid assets and ensuring quicker exit strategies, funds can safeguard against the pitfalls of liquidity crises.

Ultimately, the ability of a fund to manage its liquidity effectively is a critical component of its overall risk management strategy. Investors should be acutely aware of how their funds handle liquidity risks, as their financial security may depend on the fund's ability to respond to and recover from liquidity-related challenges. This awareness and demand for transparent, stringent liquidity risk controls could one day save you from an investment fund losing control midair and crashing toward earth.