The ability to vertically slice a portfolio is an important factor in assessing redemption risk

With the level of interest rates likely to remain low for some time, one of the ways investors are ‘reaching for yield’ involves assuming more liquidity risk. In assuming greater levels of liquidity risk investors need to consider a range of factors to ensure that the fund structure is ‘appropriate’. One of the factors which needs to be considered, though often overlooked, is the ability of the fund to be vertically sliced.

In principle, the management of liquidity in a fund is straightforward. Sufficient liquid assets need to be on hand, or certainly accessible, so that entities can meet their obligations in a timely manner. What exactly constitutes a liquid asset is more debatable, but a generally accepted definition is that “liquid assets are those that can be easily sold in sufficient volume, when needed and without incurring punitive transactions costs”. Conversely illiquid assets are those that fail to meet these criteria to varying degrees. In practice the management of liquidity is much more complex. Two key reasons for this are:

• The definition of liquidity is somewhat nebulous being best considered as a spectrum rather than a binary concept. This means that defining differences in liquidity between non-exchange traded securities is not only more subjective but is more likely to be impacted by the market conditions at the time.
• Liquidity transformation, the pooling of investors’ capital to invest in assets that are less liquid than the ‘normal’ redemption terms, is a key structural element to most investment funds. This is particularly evident when fixed income funds offer investors the right to daily redemptions while the funds themselves invest in relatively less-liquid assets; i.e. a material liquidity mismatch exists.

The realities of changing market conditions mean that in practice liquidity management is more of an art form than a science. Given this an investor needs to consider a broad range of factors in determining if the approach to liquidity management is appropriate given the underlying assets held within a fund.

One of those factors which may be overlooked by investors when considering liquidity management is how a portfolio can be sliced. Indeed, how a portfolio can be sliced can be just as, if not more, important than the proportion of liquid assets held in a fund when determining liquidity. To see why, start by considering that when investors redeem their fund shares/units for cash, fund managers can choose whether to draw on their liquid holdings or sell less-liquid assets. The fund manager is therefore determining whether to realise a slice of the fund’s liquid assets or a slice of the entire fund in order to pay for a redemption. Taking a slice of liquid assets can be described as slicing the portfolio horizontally, whereas taking a proportional slice of the entire portfolio can be described as slicing the portfolio vertically.

For investors the two actions are not equivalent as horizontally slicing a fund to pay redemptions can increase the level of liquidity risk borne by remaining investors. Consider a simple fixed income fund which has a target of 20% liquid assets (cash) and 80% in materially less liquid securities (corporate bonds). A redemption of 15% of the Fund’s AUM is now funded via a horizontal slice. Post the redemption the amount of liquid assets is down to around 6% and proportion of illiquid assets has risen to around 94%. The level of liquidity risk borne by the remaining investors has risen as taking a horizontal slice lowers the share of liquid assets held by a fund in the subsequent period and raises the share of illiquid assets. This strategy to liquidity management effectively reduces the liquidity of the fund portfolio. In contrast, vertically slicing by utilising a proportional slice of the total fund to pay a redemption, maintains the asset allocation and the liquidity of the portfolio.

A fund manager deciding between horizontal and vertical slicing as the preferable approach to liquidity-management faces an inevitable trade-off. Using cash to meet redemptions not only reduces transactions costs but also implies that assets remaining in the fund have higher expected returns. The price paid is that using cash holdings also increases the liquidity mismatch between assets and liabilities going forward. Conversely using vertical slices to manage redemptions maintains the asset liability mismatch but at the cost of the fund incurring higher transactions costs and hence lowering returns.

Evidence from the US and Canada suggests that the approach a fund manager takes depends on weighing up the trade-off, which in turn is linked to market conditions. Under normal market conditions the desire to minimise transactions costs means that funds will have a bias to undertake horizontal slicing. Using liquid assets to meet redemptions under normal market conditions reflects a normal ‘day-to-day’ liquidity management decision. Allowing liquidity buffers to meet redemption demand allows the fund manager the time to wait for applications or maturities to rebuild liquidity buffers. As a worst case, in the absence of applications or maturities, utilising the cash buffer facilitates a more orderly selldown of less liquid assets thereby ensuring that the ‘best price’ can be obtained. The result is that the aim of minimising transactions cost when meeting redemptions creates a preference for utilising horizontal slices when market volatility is low.

This changes when market volatility is high creating a bias towards the utilisation of vertical slices to fund redemption requests. The shift in fund manager behaviour arising from high market volatility is likely to be a result of the desire to manage the fund’s redemption risk; i.e. the risk of a redemption run on a fund. This link to redemption risk appears to be due to the positive relationship between redemption risk and:

• Fund Liquidity: During periods of heightened market volatility there is the increased risk that the decline in liquidity associated with utilising horizontal slices may strengthen the perceived first mover advantage with respect to unit holder redemptions. This increases the potential that the risk of further redemptions can become self-fulfilling as the liquidity buffers in the fund decline.
• Market Volatility: Empirical evidence from the US and Canada suggests that the outflows from funds increase when performance is poor. Therefore, the risk of further redemptions increases when there is a higher likelihood that a fund return will be negative; i.e. there will be a loss in asset values.

Taking these two factors together fund managers will have a greater bias to maintain the liquidity within a fund during periods of heightened volatility, even if it means that transactions costs are increased. In order to minimise redemption risk, fund managers may even seek to boost liquidity by ‘cash hoarding’. The ability of fund managers to proactively manage redemption risk by using vertical slices to pay out redemptions is an important tool not just to preserve the ongoing viability of the fund but to ultimately maximise the return to investors (1).

Funds employ a host of tools to manage liquidity and the associated redemption risk of a fund. Given the range of tools available, when considering the management of liquidity within a fund a holistic approach needs to be adopted which takes account of the overall consistency of the fund’s redemption terms with its investment strategy. In considering this overall consistency one of the key tools often overlooked by investors is the ability of the fund manager to shift between the utilisation of horizontal and vertical slices to manage redemptions. Where the characteristics of the assets in a fund preclude the ability to utilise vertical slices to maintain liquidity risk, investors need to recognise the heightened risks. In the absence of an ability to use vertical slices to manage liquidity risk, investors need to ensure that additional safeguards are in place to protect their interests in the event of an increase in redemptions during periods of heightened market volatility.