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12 11 2015 | by Victor Xing | Capital Markets

How do investment funds manage liquidity risk?

Liquidity risk indeed presents a clear and present danger for some investment funds (please see: A Junk Bond Fund Will Liquidate, and Reimburse Investors Slowly – story on Dec 10th).
Outside of boutique funds specialized in illiquid assets (such as High Yield bond funds and funds focusing on local bond issuers in smaller EM sectors), daily cash flow amongst large mutual funds can be in the range of several billions.  As long as there isn’t a rush for everyone to exit their positions (i.e. 2008, or in the case of a large bond fund following a dramatic exit of its Chief Investment Officer), most large mutual funds can sustain prolonged outflows without having to resort to fire sale of illiquid assets.
There are several mechanisms to manage liquidity risk during averse market conditions:
  1. Sell liquid assets to meet redemption – for example, if a firm faces redemption amid a Eurozone crisis, the firm would opt to hold onto its periphery European sovereign bonds (market condition simply cannot support any material selling without blowing through support levels).  Instead, they would sell liquid high quality corporate names and agency debentures or sell assets that are neutral to the on-going market volatility
  2. Replace nominal cash positions with synthetic securities.  This would be selling nominal Treasuries and Bunds to go long in their equivalents in the futures market.  Similarly, investors can replace nominal cash interest rate positions with swaps.  Both would free up balance sheet to meet redemption, without decreasing risk exposure in the rates sector (there will be additional risk exposures, such as basis between synthetic securities and cash bonds, but it is a small price to pay).  Moreover, this allows the firm to keep their illiquid positions intact, so they can be sold at a controlled pace.
  3. Use cash.  Most mutual fund managers have a percentage of their assets in cash – this cash comes from many sources – amortizing mortgage backed securities (paid off loans as a result of refinance will manifest as lump-sum cash to investors), interest payments from bonds, or dividend from stocks.
Post-crisis asset markets are less liquid, partly due to heightened financial regulations, and partly due to bond funds having more asset under management.  Thus, a rush toward the exit in today’s environment would present a significant risk to fund managers, even if there are proven measures to manage such risk.
Liquidity risk is exacerbated by larger bond funds and bigger risk positions
Source: BIS
Source: UN Redd
Liquidity risk
Private equity investments or other “hard asset” investments will be much harder to unwind – if a private equity firm had invested in couple thousand single family homes to collect rent, a sharp economic downturn would leave little time for the firm to de-risk.
Original Quora article

Next article12 10 2015 | by Victor Xing | Economics

U.S. housing market and FED’s policy normalization