Liquidity and a ‘Lie’: Funds Confront $30 Trillion Wall of Worry

(Bloomberg) -- The first blow-up shook an investment fund in Switzerland. The second and third rocked funds in the U.K.

Now, with warnings growing louder about the risks money managers have taken with hard-to-trade investments, Wall Street is starting to wonder: Just where will this end? That question is reverberating across the financial world after the head of the Bank of England warned that funds pushing into a host of risky investments -- in some cases, without investors fully understanding the dangers -- have been “built on a lie.’’

Then the central banker, Mark Carney, spoke a word few policymakers use lightly: “systemic’’ -- central bank-speak for the kind of risks that can cascade through markets, institutions and economies. Some $30 trillion is tied up in difficult-to-trade investments, he noted earlier this year.

The big worry is that the now-troubled European funds that embraced such investments, only to stumble when investors asked for their money back, are just the tip of the iceberg. Exposure to illiquid assets and poor-quality bonds has crept into funds as managers hunt for whatever returns they can find in today’s low-interest-rate world.

‘Like Air’

The question of liquidity -– the very essence of financial markets -- is now resonating on both sides of the Atlantic.

“It’s like air,” Eric Jacobson, a senior analyst at Morningstar Inc. said of the ability to readily buy and sell assets. “You can breathe it regularly, and it’s fine. But when you’re without it, you notice.”

For now, at least, few money managers or analysts foresee a full-blown crisis. But the problems GAM Holdings AG in Zurich and two other funds -- one in Oxford run by Neil Woodford, one of Britain’s most famous stock pickers, and another in London at H20 Asset Management, backed by the French bank Natixis SA -- have set the industry on edge.

The question is whether other funds could face a similar mismatch in liquidity should investors demand their money back. Even before the most recent turmoil at H20, that question caught the attention of U.S. regulators.

Fed’s Concerns

The Federal Reserve highlighted liquidity risk in bond and loan mutual funds in its May financial stability report, noting that bank loan funds purchase a full fifth of newly originated leveraged loans.

“The mismatch between these mutual funds’ promise of daily redemptions and the longer time required to sell bonds or loans may be heightened if liquidity in these markets diminishes in times of stress,” the report said.

U.S. Securities and Exchange Commission Chairman Jay Clayton warned in April that some illiquid debt securities and loans may not be appropriate for mutual funds.

“In my job, you look around and you say, ‘Where are expectations and realities out of whack?’’’ Clayton said in a Bloomberg Television interview with David Rubenstein. “If people think that those loans are as liquid as bonds, they may be wrong, so you don’t want a high-concentration of those leveraged loans in a liquidity product like a mutual fund.’’

Read More: SEC Chief Tells Mutual Fund Investors to Beware of Leveraged Loans

The troubles in Europe are reminders of the Icarus-style demise that active managers can meet when they wander into tough-to-trade products, while promising investors the ability to cash out easily.

A few fault lines could foretell risks for investors beyond Woodford and H20. Liquid alternatives, which mimic hedge-fund strategies but offer daily liquidity, have become increasingly popular. H2O’s stumble drew investors’ attention to the copycats, sparking fears that a similar liquidity mismatch could lead to a flight of capital from others and trigger a crisis.

Burned by hedge funds banning withdrawals during the financial crisis, investors in Europe thronged to funds like H2O, which provide frequent withdrawals, more transparency and typically charge lower fees. But a mix of illiquid assets and leverage can prompt investors to run for the exits at first sign of trouble, almost like a bank run.

Those problems may not be cause for concern in the U.S. yet, according to Sean Collins, chief economist at the Investment Company Institute.

“U.S. mutual funds have a strong record of liquidity management, and their implementation of the SEC’s liquidity management rule has bolstered funds’ practices,” Collins said. “Even in the rare cases when a closure is unexpected or sudden, historical experience shows that these events do not have systemic impact on the broader financial markets.”

Assuming Buyers

Still, risks lurk. Retail funds have been buying up more leveraged loans in the decade since the financial crisis. Mutual funds and exchange-traded funds owned 3% of the market at the end of 2007 and now own about 13%, according to data compiled by Wells Fargo & Co. In that period, assets under management in loan mutual funds and ETFs surged to more than $150 billion from about $17 billion.

Illiquid products may in some ways be optimal investments, but they can’t be dressed up as something easy to sell, said Mark Spindel, chief investment officer at Potomac River Capital.

“You’re assuming there’s a steady flow of buyers all the time,” he said. “Assets could deteriorate, people could make a bad decision, and people could want to get out at once. Then they need the liquidity and it’s not there.”

--With assistance from Nishant Kumar, Sally Bakewell, John Gittelsohn and Miles Weiss.

To contact the reporters on this story: Annie Massa in New York at amassa12@bloomberg.net;Craig Torres in Washington at ctorres3@bloomberg.net

To contact the editors responsible for this story: Alan Mirabella at amirabella@bloomberg.net, ;David Gillen at dgillen3@bloomberg.net, David Scheer

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