What are Liquidity and Capacity?

While it may sound complicated, it’s critical to evaluate the capacity and liquidity profile of a potential investment in a mutual fund. Exchange-Traded Funds (ETFs) trade just like stocks and are very unlikely to face liquidity issues. However, mutual funds are normally valued and traded once a day, and liquidity issues can arise in the face of significant redemptions. This is especially the case for funds that invest in relatively illiquid assets such as small or micro-cap equities, or unquoted companies, where trading volumes may not allow a stock to be bought or sold that easily.

Moreover, it’s also vital to understand when a fund’s size becomes concerning. If a fund becomes too large, the manager is likely to stop marketing to new investors in order to protect existing investors. Capacity issues can trigger outcomes such as deviation from the mandate, a change in the investment opportunity set, or liquidity issues on an underlying stock level. Therefore, monitoring investment flows on the strategy level should be a key focus.

Key Learning Points

  • Portfolio liquidity describes how quickly a fund can sell some or all of its holdings. Liquidity should be assessed under different scenarios, but most importantly under both normal market conditions and in periods of market stress.
  • Some assets are relatively illiquid, for example, smaller-company stocks or private companies. While the returns offered by these investments may look attractive (often due to the higher risk involved), the ability to sell is crucial to realize profits.
  • Evaluating a fund’s capacity is another key exercise for investors as this could have an impact on the manager’s ability to sell underlying holdings or find new investment opportunities.
  • Following the collapse of the Woodford Equity Income Fund in 2019, which was one of the most popular strategies among UK investors, the regulator and companies across the industry enhanced their liquidity monitoring systems to prevent another such scenario.

Why Liquidity Matters

Over the last two decades, the investment management industry has grown assets under management significantly, which has also increased the influence of its activities on the wider market. The vast majority of mutual funds are open-ended and offer daily trading to their clients. However, while liquid assets such as large-cap equities trade in large volumes, more illiquid assets such as small-cap stocks may be difficult to sell. Liquidity can become an issue when a fund faces a high volume of redemptions and the manager is forced to sell holdings in order to satisfy redemption requests.

How to Measure Liquidity

Data providers such as Bloomberg and Morningstar have developed a number of tools that professional investors use to evaluate a fund’s liquidity. These tools take into account the Average Daily Volume (ADV) of trading for all stocks in the portfolio and project how quickly a manager can liquidate the entire fund. The example below shows the liquidation profile of a global equity fund, considering 20% ADV (normal market conditions, while 10% and below is considered market stress or sell-off). Looking at the data, the manager can sell 39% of the portfolio within a day and over 95% in up to 7 business days. Therefore, the fund is very liquid.

What is Fund Capacity?

Fund capacity indicates how large a fund can grow before issues arise. For example, large inflows into a small-cap fund could force the manager to either increase their stake in existing holdings (which would increase liquidity risk since the manager might be unable to sell when necessary) or increase the number of holdings by investing in new stocks and potentially deviating from the targeted risk-return profile. In addition, the fund’s increasing size could also alter the investment universe as an expanded range of potential investments may be necessary to absorb the increased inflows.  There is no universal rule that investors can follow, but close attention to portfolio composition is key. As a rule, large-cap funds can accommodate more investment than those investing in small or micro-cap stocks or unlisted companies.

The Woodford Case

One of the most recent scandals in the investment industry involved one of the UK’s best-known fund managers – Neil Woodford. In 2019, following a period of underperformance, redemptions increased so significantly that the fund eventually collapsed and many investors were unable to access their funds. Although there were many red flags, such as increased exposure to unquoted companies, the regulator was slow to react, which eventually ended in one of the biggest fiascos in the UK’s financial sector.

Property Mutual Funds

One of the biggest debates in the investment industry is whether an open-ended structure is suitable for investing in physical assets. The asset class is illiquid and offering daily trading has proved to be a challenge during periods of market turbulence. Despite the introduction of specific cash requirements, mutual funds investing in property have struggled to raise cash for investors requesting redemption. Specifically, there are several open-ended property funds in the UK that have suspended trading during market downturns, most recently following the Brexit vote in 2016 and the Covid sell-off in 2020.

Assessing Liquidity and Capacity for Mutual Funds – MCQ

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Assessing Liquidity and Capacity for Mutual Funds