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Meera Hearnden: Beware the return of redemption gates

HearndenMeera

Since the financial crisis hit its nadir in 2008/2009 asset prices on the whole have performed well. Major global equity markets have rebounded, government and corporate bonds have seen their yields compressed and property prices have climbed.

Nonetheless, as global economic uncertainty increases and volatility becomes prevalent there is a risk investors may rush for the exit, causing panic selling in some asset classes. If this happens, it would not be unusual for fund providers to impose restrictions on redemptions; in other words, put in place redemption gates.

Redemption gates are used to limit the amount of withdrawals allowed from a fund during a specific period of redemption. The aim is to prevent a ‘run’ on it that could potentially stop its operations and create a large sell off of asset positions.

In July 2014, the Securities and Exchange Commission voted to approve new rules that govern money market funds. The purpose of this change was to address the risk of investors rushing for the doors during times of stress and declining liquidity.

The new rules for redemption gates state that, if the weekly liquid assets for money market funds fall below 30 per cent, a fund’s board of directors may temporarily suspend redemptions for up to 10 business days in any 90-day period and even impose fees on redemptions.

While these reforms are designed to increase transparency and to protect remaining investors during periods of stress, placing such barriers on funds is nothing new.

Indeed, the UK commercial property market came under liquidity pressures in the early 1990s and then again in the global financial crisis of 2008 when many property funds had to shut their doors on withdrawals following redemptions by investors. The issue of illiquidity in the UK commercial property market could not have been more prevalent at the time, as investors were unable to access their money for up to a year.

Similarly today, the limited liquidity of the corporate bond market is seen as a rising threat. There are concerns that when the interest rate cycle turns, bond investors may think they can withdraw their money on demand even though the assets held by their funds are long-term debt and can be difficult to sell in a crisis.

Some funds have already seen redemptions but, at the moment, groups can use other tools to manage the outflows, such as invest in more liquid derivatives, maintain large levels of cash, impose dilution levies or swing pricing. The introduction of a formal “gate” could change investor behaviour entirely. The psychology of preventing investors from accessing their capital could almost certainly result in panic selling across the asset class.

Although some restrictions may become necessary as the pace and size of redemptions in the bond market increases, these should be to protect long-term investors remaining in the fund.

Additionally, asset allocators and pension fund investors will still have a requirement to maintain allocations to fixed income assets, so the redemptions may not be as large as expected. What is more, those who sell have few places to put the investment without impacting their risk and return profile, posing a real dilemma for investors.

It is rarely ever a smooth ride in the world of investments. The risk of chopping and changing asset classes frequently can also have its drawbacks, particularly if the upturn in the cycle is missed. In the case of the bond market, while there may be a period of redemptions, we would hope the outflows are managed sensibly without the need for harsh restrictions on withdrawals.

My key message for long-term investors is that maintaining diversification across a number of asset classes and through different market cycles can lead to attractive risk adjusted returns. Investors should not lose sight of this, particularly in difficult markets.

Meera Hearnden is senior investment manager at Parmenion

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