Rikard Lundgren, CEO of Steendier and a seasoned veteran of the asset management industry, says funds liquidity must be controlled to avoid becoming a recession accelerator. Interview.
Jerome Bloch: Please, present yourself ?
Rikard Lundgren: In the Luxembourg context, I am a Non-Exec Director, Conducting Officer and Advisor, since 4 years. Before that I was a Chief Investment Officer for several Institutional Investor portfolios ranging in size from 250M EUR to 20 Bn EUR. Before that I spent 15 years in Investment Bank’s Global Market Trading and Sales.
“A fund that uses risk analysis and Stress Scenario Analysis does a pretty good job, but it is not enough.”
JB: Have you seen other crises like the one we are now in?
RL. Yes, I have been in the middle of and traded in all of them since 1987. 94, 97, 98, 2000, 2002, 2008/9, 2010.
JB: A hot regulatory topic is Liquidity of investment funds. The risk that a fund can’t sell Assets and let investors get their money back. How can that happen?
RL: It is very positive that the CSSF is putting more focus on Liquidity in funds. When I was managing money, I always had to make sure I could return that money to the capital owner, regardless of whether it was the Investment Bank’s Treasurer or the Family Office or Insurance company whose money I was managing. I had to explain to my capital owners in very clear terms what I could liquidate quickly and what would, in some market situations, take more time and sometimes even be impossible to sell if markets crash. It was then my job to make sure that my Assets would at all times reflect this promise. If I failed, and for example could not deliver money back, as promised, to the capital owner, I would have been out of a job and my career could be effectively over. To avoid this, I would keep a certain safety margin by erring on the side of having more liquid assets at all times than what I would have had if I had only prioritized maximum returns. I called it the Prudent Man Principle. Never promise more than you are sure you can deliver, even if the “shxxxt” hits the fan, as the saying goes.
JB: I guess that is what the CSSF is trying to impose on the Funds in Luxembourg?
RL: I think so too. And that is a good thing. But not easy to implement.
JB: Why?
RL: Well, the environments I was in were unforgiving in that my principals, the capital owner, could fire me at any time if I did not respect this principle. In a typical Fund format, there is often not one clear capital owner with that power. Instead there is a PPM, laws, rules and regulations to protect the interests of the collective of often less knowledgeable investors. The rules need to be clear and flexible at the same time, which is not easy. Especially as the liquidity of the assets themselves is not stable and at times even very unpredictable. This makes liquidity as a quality of the assets difficult to capture and regulate with a set of static rules or PPM paragraphs. This Prudent Man is more flexible and uses judgement rather than paragraphs.
JB: Would it not be possible to impose this Prudent Man Principle on funds?
RL: I have discussed this with lawyers, regulators, capital allocators and, Investment Managers and Traders who have experienced what it is like when markets liquidity just pulls away from you or markets refuse to set prices on some investments, even listed ones. Personally, I don’t think you can create a set of written rules that can cover all the possible scenarios of assets turning less liquid or illiquid.
JB: But what about the risk analysts? Are they not measuring how well a fund can liquidate its’ investments? Even when markets crash?
RL: Yes, I totally agree that they are very important. It is a must-have discipline to analyze liquidity risk ongoingly. But the standard measures used are only good for standard times or “Normal Market Circumstances”, which is often the disclaimer in the risk report. The often-used Stress Scenarios cover a repeat of historical crisis. So a fund that uses risk analysis and Stress Scenario Analysis does a pretty good job, but it is not enough. Why? When looking more closely at historical crises, the break-down of liquidity was often more complex than the numbers suggest. Behind a market turnover or bid offer spread number that looks ok, there can be parts of a market where there was NO liquidity at all. Credit markets in general and high yield bonds in particular are a good example. Some bonds go offer-only, with not a bid in sight. So, while there is semi-normal activity on both bid and offer side in some bonds, others are indeed totally illiquid, even within the same rating category. While the average liquidity looks not-too-bad, if your fund has more of the stuff that has no market bid, you are not helped. You are stuck!
JB: Without getting too technical can you give some examples?
RL: Let’s use the hi-yield bonds as an example. The same principle applies to many other investments also; Small-Cap equities, CLOs, Real Estate, shares in other funds i.e. fund-of-funds and accordingly potentially the shares in your own fund, especially if it promises daily liquidity to investors.
Say you are the manager of a portfolio. Markets are shaky and you want to sell some of your less loved positions to have more of your total AUM in cash. When you then try to sell a high-yield bond to the market you get a price but as you try to sell your position, the price is only good for a very small amount. The next bid price you are given is significantly lower for an equally smaller even smaller amount so you can literally feel the market running away from you when you try to sell into it. When you see how much you want to sell and how little you can get done at each level of deteriorating bids, you realize it is a really bad for your fund’s investors if you continue on this course of action. Instead you are forced to turn to other parts of your portfolio that may be easier to sell to reach the cash position you think you will need to meet investors who may want to redeem their investment with you. You are in a liquidity squeeze with nowhere to go.
JB: You mentioned the fund’s own shares as potentially less liquid. Could you expand on that?
RL: Let me use a hypothetical example. Your fund is investing in real estate or loans to companies against secure assets, such as inventory, machines, the factory and headquarters of the company. Your fund promises monthly or even daily liquidity to investors. To back this up, you have contracted a market maker to provide your investors with the possibility to redeem on any day. All good, except if the size of the market makers wallet stipulated in that contract has a maximum amount, which may not be sufficient to meet more than just a few “normal markets” redemptions. If your fund has 500M EUR of AUM and the Market Maker’s commitment to make prices and take on inventory from investors up to a maximum of 5M EUR, this could be used up very quickly. If more than 1% of all your investors get nervous at the same time, you will have to admit that you have a mismatch between your now less liquid assets and your redemption promises to investors. This happened in June last year in one of the UKs largest mutual funds, Woodford, who had to tell investors they would have to wait months, not days as they had been promised, to get maybe half of their money back. The fund had to go into liquidation and investors are still waiting to get whatever is left of their money back. That is will be significantly less than they had invested is clear.
JB: You said that every crisis is different. Please explain.
RL: In every big crisis there has been new elements that we had not seen before. These were not included in the stress tests for obvious reasons. If “Normal Markets” risk models are valid and valuable for 90 % of the time, Scenario Stress Tests cover all historical crisis events, which could be another maybe 8% of all that could happen. There is still an Unknown Unknown in each new crisis where sometimes the illiquidity we encounter could not even be imagined before it actually happened. An example: FX markets are probably the most liquid and transparent markets ever to exist. You can exchange a USD for a EURO or a Yen around the clock anywhere in the world. An FX-forward contract is the calculated combination of the exchange of two currencies combined with the interest rate differential. Therefore, FX forwards are maybe the second most liquid financial instrument or contract in the world. Nevertheless, in the -98 crisis, the Russian state through its courts, declared all FX-forwards as illegal gambling contracts and therefore null and void. This was a first. What will be the next “first” in our current crisis?
JB: What do you think it could be?
RL: I don’t know. I don’t really want to speculate either. But I cannot help but think that a significant part of the rapid declines we have seen are because of programmed trading, where selling happens because of computers being programmed to react to market prices in certain ways. ETFs are mostly programmed. Very popular. As a sub-section of Financial Markets, ETFs have grown out of all proportion to in many cases be much larger in outstanding contract volume than the actual underlying markets they represent, such as the S&P and other Stock Market indexes.
In the 2008/9 crisis CDS (Credit Default Swaps) came under a lot of criticism. A number of rules were introduced to make sure CDS would never again be the “financial weapons of mass-destruction” some described them as being. If regulators, Central Banks and Exchanges got together and decided that the uncontrolled speed of price decline we have seen lately is the fault of ETFs, we may well see their programmed trading being curbed and their liquidity neutered, to slow things down. We will see.