The European Securities and Markets Authority has published a report on the state of preparation at investment fund houses with significant exposures which identifies five areas for action.

The "priority areas," as ESMA calls them, are the good supervision of the alignment of the funds’ investment strategies, liquidity profile and redemption policies; good supervision of liquidity risk assessments; fund liquidity profile reporting; increases in the availability and use of liquidity management tools or LMTs; and the good supervision of valuation processes wherever valuations are uncertain.

ESMA chairman Steven Maijoor said: “In the wake of COVID-19’s initial impact on markets, the EU investment fund industry faced a significant deterioration in liquidity in some segments of the fixed income markets as well as valuation uncertainty in the real estate sector. This coincided with large-scale investment outflows from investors.

“The funds in question managed to respond adequately to redemption pressures. However, [we have] identified a number of priority areas that funds and supervisors should focus on to address potential liquidity risks in the fund sector.

The "redemption shock" which ESMA links to the current pandemic happened over a short period of time, with governments and central banks intervening to steady the markets in which these funds invest. Some funds might have suffered from "liquidity mismatches due to their liquidity set-up," especially when they invested in asset classes that were illiquid by nature while offering a combination of high redemption frequency and short notice periods. ESMA also worries about the valuation of portfolio assets, especially for real estate funds, which do not frequently use LMTs.

Against this background, ESMA says that fund managers authorised under the Undertakings for Collective Investments in Transferable Securities (UCITS) and Alternative Investment Fund Managers' Directives should prepare for future shocks. It has promised to "chase up" national regulators on the subjects of liquidity risk management and valuation in stressed market conditions.