Liquidity risk is incredibly difficult to forecast and, if past experience is anything to go by, it is even trickier to predict during times of market stress. Ironically, it is often these times when liquidity is needed the most.
It is a complex issue, given that liquidity risk begins at the individual security which, in turn, is rolled up to the fund level. But what about the risks to outcomes for clients?
Liabilities such as income need to be funded by a portfolio, but the portfolio may experience expected and unexpected demands for liquidity - particularly during challenging times for markets.
These anticipated redemptions therefore need to be matched with the portfolio's ability to supply the liquidity and income.
This calls into question the role of fund performance, given that high returns do not equate to adequate liquidity. The market will not always be available to turn wealth into cash, especially for illiquid securities.
Cash, reliable cashflow and unencumbered assets are the only robust sources of liquidity and they need to be managed like any other fund and business risk. However, the outlook for liquidity risk is improving.
Over the past 30 years, markets have generally exhibited increasing degrees of liquidity due to improvements in finance theory and market infrastructure, as well as the dramatic fall in computation costs which have made transactions quicker and easier.
A pivotal moment of change though was shortly after the 2008 Global Financial Crisis. The event proved that, without the necessary liquidity, nothing much matters.
The credit crisis resulted in poorly understood securitised mortgage products spilling out into most financial activities around the world.
The original attraction of securitisation was that it provided ways for investors to easily and efficiently obtain portfolio diversification through ownership of different types of market beta.
One of the lessons learned from the credit crisis is that the industry needs to be more hands-on, and to develop a deeper and more direct understanding of the underlying assets.
This includes the behaviour, incentives and current practices of the borrowers (within the securitised products), services and the organisation process (product governance).
What has changed?
The Global Financial Crisis led to some key changes, which include a renewed focus on identifying the potential for conduct risk and protection for investors. For example, the implementation of MiFID II.
A key requirement now is that, at all levels within an asset management firm, conduct risk must be monitored throughout the investment service value chain. Businesses need to pre-empt times of difficulty rather than just expect that the 5% probability error will never happen, because it did and markets have long and unforgiving memories.
Investment management now has a greater focus on risk reduction and controls. Firms have the oversight to make sure a fund is operating in a regulated way, and that it is protecting the end-investor through value for money and product governance.
For instance, there is a greater emphasis on protecting investors' capital better in volatile and stressed times, compared to over-leveraging a fund to take advantage of market gains.