Managers should remain aware that fund liquidity continues to be an ongoing concern for regulators, both in Canada and south of the border. In Canada, a mutual fund must invest primarily in liquid investments in accordance with National Instrument 81-102 - Investment Funds (NI 81-102). In June, 2014, the OSC commenced a series of targeted reviews of mutual fund practices relating to liquidity assessments of fund holdings, liquidity stress testing and liquidity valuation considerations. A notice summarizing the OSC's findings was released in June, 2015. Please see our July 2015 bulletin detailing this notice.
Some of the key recommendations made by the OSC are as follows:
- Funds should have robust written policies and procedures regarding how they make liquidity assessments both at the time of an investment purchase and on an ongoing basis. Some key metrics useful in making liquidity assessments include: volume metrics, bid-ask spreads, numbers of participants making a market for the holding and outstanding issue size. Further, it is advisable to have an assessment or review committee to determine whether a security is illiquid.
- In Staff's view, being listed on a stock exchange is not generally sufficient to conclude that a particular holding is liquid. Managers should consider whether or not a fund's investment holdings can be readily disposed of in 3 business days without a significant adverse impact to the portfolio.
- It is important to engage in stress testing on an ongoing basis to have a solid grasp of a fund's ability to meet unexpected large redemptions, both at historical and higher than historical levels, together with market stress. Both a stress testing policy and a procedure should be in place to deal with such scenarios. A fund with a higher exposure to potentially illiquid assets should provide additional disclosure to its investors and ongoing discussion of the risk management policies and investment restrictions in place designed to mitigate liquidity risk.
- Finally, Staff considered valuation practices and referred funds to International Financial Reporting Standards 13 (IFRS 13) “Fair Value Measurements” which sets out guidance for determining fair value, as well as the accompanying disclosure requirements. Managers should obtain standing instructions from the funds' IRC in regard to their valuation policies and procedures.
The Securities Exchange Commission (SEC) continues to be concerned with liquidity in the fixed income markets generally and in open end mutual funds and ETFs in particular. Under proposed reforms, mutual funds and ETFs would be required to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices.
The SEC's proposed reforms would require a fund's liquidity risk management program to address: classification of the liquidity of fund portfolio assets based on the amount of time required to convert an asset to cash without market impact; assessment, periodic review and management of a fund's liquidity risk; establishment of a fund's three-day liquid asset minimum; and board approval and review. It would also codify the 15 percent limit on illiquid assets including in current SEC guidelines.
The proposed reforms also provide a framework under which mutual funds could elect to use "swing pricing" to pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. These proposals would enable mutual funds, subject to board approval and oversight, to reflect in a fund's NAV costs associated with shareholders' trading activity.