The financial news media in the UK has been covering the on-going story of Woodford Investment Management preventing investors withdrawing assets from one of its pooled funds. In a nutshell, the story is that a pooled fund that offered daily liquidity held illiquid assets. In the face of large redemption requests it began to run out of liquid assets to pay its investors. Eventually this lead to the decision to suspend redemptions from the fund.
As long as investors in the fund were confident that the illiquid assets were good investments and that they could get their money out of the fund, all was fine. This was the state for many years. However, once investors lost confidence, those assets became a problem as investors began to redeem from the fund. As the most liquid assets were sold to meet redemptions, the problem of the illiquid assets grew, ultimately leading to the fund suspending redemptions.
We believe that the scenario that is playing out is an example of the network effect in financial markets creating a positive (amplifying) feedback loop between investors wanting their assets returned and declining portfolio liquidity. We discussed this effect as an ecosystem case study in 2017. This case study showed how the actions of investors within a fund’s ownership network could lead to a fund suspending redemptions. Although the case study described hedge funds in the 2008 crisis, we believe the same dynamic has occurred here as well.
Similar to the example in the case study, in the Woodford event we observe a mismatch between fund liquidity and underlying asset liquidity. This mismatch interacts with investor behaviour to create a positive (amplifying) feedback effect that results in increasing redemptions, declining fund liquidity and eventually the fund suspending redemptions.
As highlighted in our previous work on investment as an ecosystem, this type of risk is often overlooked in traditional risk assessment. Even a liquidity analysis of the portfolio will not typically consider what would happen in this type of event, rather it will consider what would happen if the investor undertaking to the analysis were to sell in isolation. Of course, the rationale that prompts one investor to sell (personnel change, corporate change, style drift, poor performance) is likely to prompt other investors to sell as well.
Events where a fund becomes a forced seller of illiquid assets often involve leverage and margin calls, but this one involved only synchronised investor behaviour that triggered sales, coupled with mismatched fund liquidity terms. This highlights that this type of risk applies not only to hedge funds but to any fund where a liquidity mismatch exists between its underlying holdings and fund terms.
The investment industry is grappling with competing liquidity priorities, including an increasing interest in owning private assets and the growth of DC investors. Analysing the investment ecosystem becomes more important than ever for asset owners and asset managers.