The problem with the stocks in the Woodford fund is that over time the levels of illiquid assets held in the fund increased, ultimately heightening the liquidity risks that caused the fund to be suspended.
Samuel Jackson, chief risk officer at Yealand Fund Services, says: "We would not expect to see a 100 per cent market participation rate used in fund liquidity monitoring even for as a normal participation rate, as the output will only establish the liquidity of the fund in ideal market conditions.
"In our view a 30 per cent market participation rate is an appropriate rate to use for normal market conditions and a 15 per cent market participation rate or below for stressed market conditions, as this will provide a truer fund liquidity rating for differing levels of stressed market conditions."
The FCA does not set out a prescriptive way to monitor and manage liquidity risk, but over the years it has increased its scrutiny over liquidity management.
The ACD is responsible for coming up with its own metric for monitoring and measuring liquidity risk, which it must be able to fully justify and evidence as robust in normal market conditions under FCA scrutiny.
The model must also be stress-tested against difficult market condition scenarios.
Last year the regulator published findings from its multi-firm review of liquidity management frameworks and set out a guide to good practice.
The Liquidity Management Multi-Firm Review was done to assess the progress that firms were making in implementing effective liquidity management frameworks, following a letter sent in November 2019 to the boards of authorised fund managers – another name for ACDs – detailing good practice in liquidity management.
While an ACD delegates the day-to-day running of the fund to the investment manager, the FCA still regards the ACD, rather than the investment manager, as being responsible for how the fund is managed.
The ACD does not delegate investment risk management, of which liquidity risk is a key component.
With few exceptions, the FCA found that many firms under its review did not attach sufficient weight to managing liquidity in their frameworks and governance structures.
In its findings, the FCA also said its board and committee-level discussions on liquidity risk and associated reporting packs fell short of expectations.
In many cases, liquidity risks were flagged only on an exceptions basis, resulting in committees discussing liquidity issues in isolation, where a wider context would be of benefit.
Likewise, the FCA said it saw very little evidence of focus on the composition and evolution of less liquid "buckets" within funds in general. Some firms did not have processes in place to accelerate governance in times of stress.
The FCA said: “We found that firms’ approaches to stress testing methodologies varied from highly sophisticated in-depth models to basic tick-box exercises. Many firms in their models used the less conservative approach of assuming the most liquid assets would be sold first, creating a false sense of security, and affecting portfolio composition if executed.
