Four things Covid-19 has taught us about the resilience of the fund management industry
By Xavier Parain (pictured), CEO, FundRock Management Company – The impact of Covid-19 has altered the mechanics of almost every profession, and the fund management is no different. Here are four things that we have learnt about the way that fund managers have mitigated systemic risk during the crisis and slowed the spread of market contagion.
The past decade’s investment in IT infrastructure has paid off
Business continuity plans and procedures, tested more frequently than ever implemented in the past, have been deployed universally. Front-, mid- and back-office fund management professionals immediately and seamlessly transitioned to working from home, crucially, without any major impact for investors.
Whether this is the positive, albeit unintended, consequence of increased investment in IT infrastructure by financial institutions over the past decade or simply the result of a highly digitised world, it is reassuring to see how smoothly the transition took place.
Liquidity management tools no longer controversial
During the global financial crisis (GFC) of 2007-8, we saw a “run” on investment funds when many imposed restrictions on redemptions. The move caught many off guard, including policymakers, regulators and many investors. It was frequently overlooked that these measures helped mitigate systemic risks and stabilised markets, with critics instead focusing on the perceived lack of transparency around the decisions to enact them. Many managers who’d utilised them during the GFC suffered considerable reputational damage and struggled to rebuild their businesses as the recovery continued.
Clearly, today’s crisis is different to the GFC, but there are striking similarities. As in 2007, in March as the Covid-19 outbreak gathered pace globally we saw extraordinary levels of volatility in financial markets. We also saw – as we did during the GFC – certain jurisdictions ban short selling and funds temporarily restrict redemptions. So, what’s different this time around?
Most significantly, the regulatory environment. Despite the controversy of their use at the time, since the GFC, regulators have encouraged fund managers to develop and use liquidity management tools, but to be transparent with investors when doing so.
This shift in regulatory outlook will be codified in September, when guidelines on liquidity stress testing for EU-domiciled mutual funds and alternative investment funds, such as hedge funds and private equity funds, come into effect. The guidelines, published by the European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, are based on globally agreed principles developed in the wake of the GFC. They present a mechanism by which managers regularly test the resilience of their funds to different types of market risks, including for liquidity risk, and report their findings and actions to local regulators. In response to the Covid-19 pandemic, many fund managers sought to implement these measures ahead of the deadline later this year.
During this crisis, we’ve seen liquidity management tools deployed in a fashion that mitigated many of the risks associated with such high levels of market volatility. Redemption deferrals were used, usually only for a few days, to allow fund managers to liquidate assets in difficult trading conditions, while some portfolio managers have used fund gating to ensure the accurate valuation of assets.
Reduced volatility doesn’t always equate to a reduction in liquidity costs
Liquidity cost calculation is a parameter that is difficult to calculate, even on the most liquid of assets, and is based on the horizon of trading parameters, such as bid-ask spreads, transaction cost and market impact. In normal market conditions, these hidden costs fluctuate broadly in line with market volatility for highly liquid assets like equities. However, the crisis highlighted the need for managers to monitor this measure closely.
In Q1 of 2020, liquidity costs roughly doubled consistent with market volatility. However, in Q2 liquidity costs continued to rise despite a reduction in volatility. While markets settled following the initial shock of Covid-19, it remains the case that it is more difficult and expensive to find buyers, unwind positions and settles transactions. For managers to have the ability to successfully respond to the ebbs and flows of investor activity, they need accurate monitoring of the true liquidity of assets.
Fund management remains resilient… so far
It is still too early to assess the full impact of Covid-19 on the fund management industry. A second wave of the pandemic in certain countries is likely to result in heightened market volatility once more. However, what we have learned so far is that the sector is much better equipped to deal with systemic shocks.
Both managers and regulators have significantly improved their arsenal when it comes to mitigating the impact of volatility in the form of improved technology, management infrastructure and more sophisticated liquidity monitoring. Compared to 2008, the industry is much better positioned to manage an even deeper crisis.
Xavier Parain is the Chief Executive Officer of FundRock and was previously Managing Director at the Asset Management Directorate at the Autorité des Marchés Financiers (AMF), the French financial markets regulator