A surge in volatility-driven flows could impact investor equity as brewing liquidity issues and a spike in trading costs spills through many NZ funds, according to Minter Ellison Rudd Watts.
In a just-published note, Minter Ellison partner, Lloyd Kavanagh, says NZ fund managers may have to turn on buy/sell spreads or “agree amendments [for governing documents] now with the supervisor/trustee, in the interests of all investors”.
“Until recently, many New Zealand managed funds have provided for new investments and redemptions in and from their funds to occur based on its [net asset value] NAV,” Kavanagh says. “But large flows in and out of funds can raise questions as to whether the costs are adequately addressed by the NAV calculation, and are fair to all relevant parties.”
Without buy/sell spreads, transaction costs accrue to remaining investors as others flow in and out – a problem that gets amplified during difficult trading conditions.
While NAV-based entry and exit methods ultimately translate trading expenses to a drag on fund performance, buy/sell spreads allocate explicit costs to investors who make the transaction.
And those trading costs have ballooned in recent days, especially in fixed income markets, emerging as a blow-out in spreads.
Last week, for instance, Vanguard Australia rolled out new pricing for its range of retail and wholesale products that saw a more than 10-fold increase in sell spreads for some fixed income funds. The passive management giant also increased the buy and sell prices for its equity funds by .03 per cent.
According to the Vanguard fact sheet, the new sell spread for its Australian Corporate Fixed Interest Index Fund rose from 0.15 per cent to 1.79 per cent as at March 18. Likewise, the Ethically Conscious Global Aggregate Bond Fund – both the NZ and Australian dollar hedged versions – saw a jump in the sell price from 0.13 per cent to 0.82 per cent.
“The volatility in investment markets has increased dramatically following the uncertainty driven by COVID-19,” the Vanguard note says. “This has been the case particularly in fixed income markets, where trading costs have risen significantly. In addition, funds employing currency hedging have also been impacted with an increase in foreign exchange transaction costs.”
Other managers, including Russell Investments, have updated buy/sell spreads to reflect the altered circumstances.
Anthony Edmonds, Implemented Investment Solutions (IIS) founder, said buy/sell spreads represented the fairest way to apportion costs across investors.
“Many NZ managers don’t use spreads,” Edmonds said. “But investors who stay in those funds as others move in and out end up wearing those costs in performance.
“While the spreads can look like an unnecessary expense to some investors, the alternative leaves incumbent fund investors at a major disadvantage that increases over time – and becomes particularly painful during market volatility.”
He said more funds would widen spreads as the downturn continued.
The massive jump in sell spreads in fixed income and credit funds – often the first market to feel liquidity stress in times of crisis – could serve as a barrier to exit for some investors.
Of course, other investors don’t get the choice as rebalancing and risk management rules included in statements of investment policies and objectives (SIPO) set a course of action.
David Beattie, principal of the Wellington-headquartered Booster, said it could be tricky rebalancing diversified portfolios in the current environment.
But Beattie said Booster was managing the process well despite the widening credit and fixed interest spreads.
Booster invests via the Vanguard Ethically Conscious Global Aggregate Bond Fund, which allocates about two-thirds to sovereign bonds and the remainder to credit.
“The spreads have pushed out but there’s been no problem with liquidity, which is the benefit of investing in a large diversified fund,” he said. “I don’t envy those who are rebalancing out of pure credit funds right now.”
Sam Stubbs, founder of Simplicity, which also invests through the Vanguard fixed income funds, said the spread jump has yet to cause a problem for the manager – albeit that rebalancing transactions would come at a higher cost to the fund.
Most funds usually rebalance at month-end but managers, and supervisors, do keep closely monitor ongoing conditions for SIPO breaches and the like.
Kavanagh says in the Minter Ellison note that funds can tip over SIPO limits either passively – for instance, when falling equity markets create an over-weight fixed income position – or through active choice, such as building up cash reserves.
“Fund managers are checking carefully the wording of their SIPOs to see what leeway there is to respond to the current market conditions,” he says. “Some were drafted (with the benefit of insights gained during the global financial crisis) to allow discretion within wide ranges, while indicating a target. Others set tightly defined limits of the proportion of the fund that can be held in specified asset class.”
Managers must advise fund supervisors of any “material” limit breaks, Kavanagh says, with the reporting threshold dependent on “the nature or type of investments that can be made and the proportion of each type of asset”.