Why Fund Managers Are Scared of Sudden Withdrawals  

(Bloomberg) -- When M&G Plc, a U.K. property fund, announced it was freezing withdrawals on Dec. 4, mom-and-pop real estate investors were introduced to a term that’s already caused pain elsewhere in European bond and equities markets: liquidity mismatch. It’s what happens when funds that promise unrestricted redemptions put money into assets that are hard to sell in a pinch. That contradiction led the head of the Bank of England to warn earlier this year that some funds were “built on a lie.” Some observers compare the situation to a bomb hidden in the markets, ticking away and set to go off come the next downturn.

1. What’s causing mismatches?

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 funds that traditionally focused on liquid securities have been edging into more rarefied corners of the market to eke out returns in today’s world of low or negative interest rates -- a movement known as “style drift.” But many of those higher-yielding assets are in thin or quirky markets, making them potentially hard to trade. Real estate is perhaps the most illiquid asset of all, often taking months to unload.

2. Why is that such a problem?

Remember bank runs? Before deposit insurance, they were a regular occurrence because of the liquidity mismatch inherent in banks -- institutions that convert customer deposits available on demand into long-term investments. For investment funds, a sudden rush for the exits can create something similar. That can leave them with a choice of selling off assets at fire sale prices, potentially weakening themselves further, or closing the door to redemptions, a step that can erode market confidence more broadly.

3. What prompted these worries?

M&G froze its flagship 2.5 billion-pound ($3.3 billion) U.K. real estate fund after being hit by mounting redemptions. Carney’s comments came in June, after one of Britain’s most famous stock pickers, Neil Woodford, froze withdrawals from his flagship equity fund, and a global macro fund run by H2O, which is backed by Natixis SA, saw billions of dollar’s worth of withdrawals over investments in unrated bonds. Earlier, Swiss asset manager GAM Holding AG, froze redemptions in some funds after its dismissal of star bond manager Tim Haywood led to a rush of withdrawals.

4. Hasn’t this happened before?

Yes. In 2016, property funds stopped investors from taking out their money when withdrawals spiraled after the U.K. voted to exit the European Union. The M&G money pool was one of seven major U.K. funds managing more than $20 billion to halt trading at that time. To fix the problem, U.K. property funds -- which managed 29.3 billion pounds as of the end of October -- have been raising their cash levels. But the real estate market in the U.K. is slowing and the value of malls and stores, in particular, is plunging. That could make it even harder for funds to exit their bets, especially if they’ve offloaded their healthier properties first.

5. What’s driving it?

Something that’s referred to as “the reach for yield” -- and managers have been reaching further and further lately. Returns on safe assets plummeted in the 2008 financial crisis and have stayed low ever since. For example, 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.K.’s Financial Conduct Authority said it was working with M&G to ensure that “timely actions” are undertaken in the best interests of all the fund’s investors. The U.S. Securities and Exchange Commission has been concerned about mutual fund liquidity since at least 2015. The SEC now limits fund holdings of illiquid securities to 15%, and the funds are required to provide a confidential breakdown on the liquidity of their holdings to the regulator. As of June, they must also include a discussion on how they manage liquidity risk in annual reports to investors. 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, the number of U.K. funds that have closed and blocked redemptions so far is relatively small compared with the hundreds of U.S. funds that close annually because of shrinking assets or investment losses.

7. How big a problem is this?

A lot of money is potentially at risk, though there’s debate over how acute the dangers are. Carney cautioned that the problems are “systemic,” with some $30 trillion tied up in illiquid or 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 arranged by banks. Defenders of bond ETFs point to the way they weathered previous bouts of market turmoil. But Michael Burry, an investor whose bet against the subprime bubble was featured in “The Big Short,” warns that “the theater keeps getting more crowded, but the exit door is the same as it always was.”

The Reference Shelf

• Bloomberg News coverage of M&G’s travails.
• A QuickTake on ETFs and liquidity worries.
• Bloomberg News on the turmoil on GAM, Woodford and H2O.
• Recalling when Third Avenue Focused Credit Fund froze withdrawals.
• The SEC’s June 2019 Final Rule on investment company liquidity disclosure.

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

To contact the editors responsible for this story: Shelley Robinson at ssmith118@bloomberg.net, John O'Neil, Andy Reinhardt

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