The ultimate measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy. The same can be said of fund managers.

Fund managers managing long-only open-ended funds can’t be sleeping well lately. The Covid-19 pandemic has hit stock markets hard with volatility at an all-time high and share prices at levels last seen during the 2008 financial crisis.

Fund managers also face the risk of investors rushing to redeem their shares in the fund, which during normal times can be anticipated and met with cash reserves or by selling-off some positions in the fund to pay out redeeming investors. However, in times of market panic, like what we are witnessing at present, effective liquidity management is key to ensuring that the fund survives this pandemic and the reputation of the fund manager remains intact when this over. Liquidity issues are exacerbated when a fund’s shares are held by a few large investors, where a single unanticipated redemption could result in the fund having to suspend redemptions or even to wind down.

Poor counsel by law firms and other advisors not having any practical insight into the intricacies of managing a fund or who have no interest in ensuring the longer-term viability of a fund after having been paid their fees, may cost a fund manager reputational damage or worse, their job.

Liquidity management measures are not something that can be implemented arbitrarily, without such being properly defined and disclosed in fund offering documentation and the mechanics of such measures carefully reflected in the fund’s constitutive documents. Moreover, even when such disclosure is made, managers must be prudent in their choice of liquidity management measures and their application. If liquidity management measures do need to be applied, they should be applied fairly, lightly, transparently and communicated to investors in a non-legalistic manner. Investors may not redeem during the stressed scenario but are likely to do so once it is over if the manager has implemented overly aggressive liquidity management techniques or has acted in a non-transparent manner. Many managers that relied on a temporary suspension of or limitation on redemptions during the 2008 Global Financial Crisis were criticised and their judgement questioned when markets recovered.

While in some cases, liquidity management measures were essential to ensure the survival of the fund, in others, they could have been avoided or applied less aggressively. For instance, liquidity risks could have been mitigated had some funds set a dealing frequency that was more realistic and appropriate for its investment objectives, strategy and the liquidity expectations of its investors. Another useful tool to manage liquidity risk is for offering documents to prescribe a notice period that is sufficiently long to allow the manager to know well in advance what the fund’s liquidity needs will be and take appropriate action in time to meet the redemption request. At the same time, the notice period cannot be too long, which would not be in investors’ best interest. It may make sense to reserve the right to extend the fund’s redemption notice period in times of stressed scenarios.

IOSCO’s 2018 Final Report on Recommendations for Liquidity Risk Management for Collective Investment Schemes (hereinafter ‘the IOSCO Recommendations’) provide funds with a useful reference point against which to assess their own liquidity management practices. The IOSCO Recommendations are by no means a ‘one size fits-all’ solution and fund managers are expected to exercise their sound professional judgement in the best interest of investors.

The IOSCO Recommendations are designed to support the effective exercise of that professional judgement in both stressed and normal market conditions. The recommendations set out an approach under which fund managers are expected to monitor and evaluate the underlying portfolios of their fund in light of stressed market conditions and other relevant circumstances in order to determine whether or not to activate additional liquidity tools and, when activated, the manner (e.g. through a single or a combination of liquidity tool(s)) and timing of implementation. Appropriate management of liquidity will also help minimise the potential that the fund could transmit stress to the market. In addition, the IOSCO Recommendations describe a range of initiatives during both the pre-launch/design phase of the fund and the on-going day-to-day operation in order that fund managers can appropriately manage liquidity and have contingency plans in place to implement the additional liquidity management tools as needed.

The following are some of the key liquidity management tools that fund managers can use. Some of these may not be available in particular jurisdictions owing to regulatory restrictions.

1. Retaining sufficient cash balances to satisfy redemption requests, based on data from past liquidity stress testing results.

2. Ensuring portfolio diversification and avoiding asset concentration.

3. Use of redemption fees that may be scaled down over time.

4. Dealing frequency should be consistent with investor liquidity needs and the fund’s investment universe.

5. Deferring all or part of redemptions to a future date. Care should be taken to carefully define the circumstances when this can be done in the fund’s offering documents. One may find that the fund is not legally permitted to defer redemptions in the case of the current market panic.

6. Suspending redemptions either indefinitely or for a period of time. Again, care should be taken to carefully define the circumstances when this can be done in the fund’s offering documents.

7. Allow for the creation of side pockets, where illiquid investments may be held until the stressed scenario is over. While side pockets can easily be catered for in fund offering documents, they are burdensome to apply from an administrative standpoint.

8. Providing for redemptions in kind, where the fund may pay out redemption proceeds in a pro-rata distribution of assets it holds, rather than in cash. This technique may not be appropriate for retail clients and passes on any risks and issues related to a particular asset to the underlying investor.

9. Funds may also be able to borrow in order to temporarily fund liquidity needs. This, of course, would need to be permitted in the fund’s offering documentation.

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