Stress Testing Funds Can Only Be A Good Thing

They say size matters. A somewhat seedy suggestion that is re-hashed across headlines time and time again to emphasise that the size of the fund you are invested in has an impact on liquidity – namely, how easy it is for you to buy into and sell out of your holding.

But when I read the International Monetary Fund’s (IMF) bi-annual Global Financial Stability report, which said asset managers should be subject to stress tests similar to that of the banks, it posed a challenge to this stock phrase. These tests are apparently designed to prove to customers and regulators that funds could handle a mass rush to the exit in case of a downturn, and there is more of a focus on assets than fund size.

All four UK banks passed the stress tests of last winter, some with a clearer margin than others, but it is yet to be seen whether fund houses will sail through. Consider that banks were quick to be blamed and kicked into humble submission after the financial crisis of 2008, but fund houses are only more recent subjects of scrutiny.

Stress Tests For Funds?

The IMF would like to see regulators take a more “hands on” approach and provide increased oversight of risk indicators. The call comes at a time when a handful of funds dominate investors’ assets – look at those huge corporate bond funds from M&G – and where a brand can mean more than performance - Neil Woodford springs to mind. Certain funds will charge customers a premium for their liquidity – look at how iShares maintained higher annual fees on its larger and more liquid distributing share classes on certain equity ETFs.

Stress tests are old hat to investors in the U.S., where regulators are already considering this issue, prompted by the massive outflows from the PIMCO Total Return Bond Fund in 2014. But to UK investors, who have so far been obsessed with the likes of annual headline fees and the use of derivatives, this focus on fund size could be a game changer for the asset management industry.

Size Does Not Equal Systemic Risk

Size is not everything. The IMF said the following in its report: “Unlike banks, larger funds and funds belonging to larger asset management companies do not necessarily contribute more to systemic risk.

“Rather, the nature of the assets they invest in appears to be relatively more important than size. This is an important factor to consider when trying to find the best ways to identify systemically important asset managers or products.”

This is certainly true. The S&P 500 is much more liquid than, say, a fund invested in property.

However, size does come into it.

Think of those Europe-listed ETFs that are languishing on exchanges with less than £100 million in assets, of which there are plentiful, which do not even make a profit for its issuer and deter investors with the perception of a lack of liquidity. And then think of the extremely large ETFs, with billions in assets – what would happen if everyone wanted to sell out, in either scenario?

The fact is we have no idea, because it has never occurred to date in an ETF.

Massive ETFs

Today, incidentally, is the 15^th anniversary of the launch of the first Europe-listed ETF, according to iShares with two of their Euro Stoxx 50 funds. This was followed by the iShares Core FTSE 100 UCITS ETF, which has grown to £3.7 billion in assets under management.

On the one hand we seem to be celebrating a massive increase in assets, inflows and trading volumes, and on the other hand regulators are clamping down on anything that appears to be getting too big for its boots.

So far, ETFs seem to have been left out of the IMF equation, but it could only be a matter of time. After all, they are public and transparent funds, which call out for easy scrutiny, as has happened with securities lending and synthetic replication in the recent past.

Too Large, Too Small, Never Perfect

Your fund is too small, your fund is too large – the goldilocks scenario is at best perplexing and at worst leaves advisers totally confused as to how they can measure liquidity, what size of a fund justifies what premium, and what fund size is just right for them and their client. And in a world of powerful marketing messages and retail fund stars, the winner-takes-all mindset is unlikely to fade in the near future.

Ultimately the stress tests on fund houses are designed to benefit the end investor. Forcing the dominant players to prove their worth alongside their pricing can only be a good thing.