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Listed Equity Bulletin 23 February 2021

Share price volatility, risk and liquidity

The impact on companies, investors and the cost of capital

Executive summary

• Companies exhibiting higher levels of volatility are perceived to carry more investment risk. Investors then require a higher rate of return which impacts a company’s cost of capital.
• Individual fund structures and elements of investment portfolio construction methodology can cause dramatic spikes in share price volatility, often uncorrelated with a company’s underlying prospects.
• Volatility events can cause particular liquidity issues for open-ended funds when those funds cannot sell assets fast enough to meet investor redemptions.
• The more diversified the shareholder base and the investment vehicles, the less problematic potential liquidity mismatches become.
• Fund managers are becoming increasingly focused on share price volatility and the liquidity risk in their portfolios.
• The less risky the business model is, or is perceived to be, the lower the share price volatility. The lower the volatility, the greater the incentive for investors to accumulate a more significant position.
• A perception study is a powerful way to understand investor attitudes and alignment and identify ‘stranded’ shareholders.
• A fundamental quantitative approach to investor targeting results in greater alignment, matching a company’s investment characteristics with a fund manager’s investment goals.
• An effective investor communication strategy builds credibility, ensures a supportive and aligned investor base and reduces volatility.
• The share price is then more likely to reflect the company’s long-term value, resulting in an improved valuation and a lower cost of capital.

Introduction

From the global financial crisis in 2008 to the Covid-19 pandemic in 2020, the past 12 years is punctuated by events that resulted in a dramatic increase in the volatility of global equity markets and share prices. Volatility is defined as the measure of how much a stock or index fluctuates versus historical market movements.

Executives of listed companies need to understand the direct impact volatility has on an investor’s decision making. Companies with higher volatility are perceived to carry more investment risk and therefore, investors will require a higher rate of return on their investment. This directly impacts a company’s cost of capital.

This document is designed to help executives of listed companies. The goal is to explain how both individual fund structures and elements of investment portfolio construction methodology can play a part in this increased volatility, often resulting in material share price movements uncorrelated with a company’s underlying health and prospects.

Scope

This paper’s scope covers active rather than passive investment and the fund structures that are used. Active management includes long-only funds as well as long/short or ‘hedge’ funds.

The costs of physically managing these assets impact the overall performance of a portfolio and fall into two categories:

1. Explicit costs: trading commissions, taxes, research costs and custody fees.
2. Implicit costs: the frictional trading costs associated with the price impact of buying and selling portfolio positions – the difference between the price of assets before an order is placed versus the price at which it is traded.

The investment vehicles used to deliver products to clients, the implicit costs they generate and their impact on the share prices of publicly quoted companies is the focus of this note.

Fundamental objectives of ‘active’ asset managers

An active investment manager’s success can be defined as their proven ability to consistently deliver investment returns (after fees) over their stated benchmark over a specified period. A benchmark is typically an equity index, or in the case of some funds, cash. Above-average returns are sometimes referred to as alpha.

Investors have a wide variety of return objectives and risk appetites that they are willing to tolerate to achieve their investment objectives. The fund management industry has evolved to offer many funds whose investment styles are designed to meet investors’ objectives. To achieve their alpha quest, active fund managers adopt different investment styles (value, size, momentum, volatility, quality, yield and growth). These styles form the foundation for selecting individual securities and are then blended together to try to deliver the best overall return possible.

This is known as portfolio construction: understanding the client’s return objectives and taking an acceptable level of overall risk to achieve them. Effectively blending the right combination of individual corporate risk with the macro risks generated from combining the stocks into a portfolio (such as over/underweights to countries or sectors).

Investment vehicles can make a difference

Investors typically use a small number of structures to hold portfolio investments. Several considerations influence the type of fund structure: investment strategy, size of fundraising, duration of the fund, redemption characteristics, unit price calculations, leverage, fees and the desired returns. The potential impacts these holding structures have on the underlying share price movements need to be understood.

• Closed-ended vehicles such as investment trusts. These investment companies raise a defined amount of money through a listing and then trade on the public markets. They are the perfect vehicle for long-term holdings, as buyers and sellers have no impact on the underlying fund activity but simply move the fund’s share price. The only caveat is a discontinuation vote, seen more regularly in smaller trusts trading at a persistent discount. A discontinuation vote may result in the liquidation of holdings of the fund with the proceeds returned in cash to shareholders.

• Institutional funds. Here a fund manager runs a segregated mandate as part of a wider corporate, public pension or sovereign wealth fund. This is another appropriate vehicle for long-term investing as there are very few cash in or outflows that require the fund to rebalance. However, this carries considerable tail risk if the client decides to change the fund manager. The assets are then transferred to a new manager who ultimately decides which assets to keep and which to sell and restructures the portfolio accordingly.

• Open-ended funds. The most common examples are Open-Ended Investment Companies (OEICs) or Undertakings for Collective Investments in Transferable Securities (UCITS), unit trusts regulated in the UK and the EU. Potentially this is the most dangerous place for a sizeable long-term shareholding, as these products promise instant liquidity, requiring immediate transactions in the underlying stocks. The less liquid the underlying assets, the more distorting these transactions can be. The public collapse of Neil Woodford’s Equity Income Fund is the most high-profile example of the damage caused by a liquidity mismatch in an open-ended fund.

• Wealth management discretionary portfolios. A group of private clients gives the fund manager discretion to buy stocks on their behalf, but in practice, the fund manager typically runs several integrated model portfolios, with the underlying stocks then allocated pro-rata across all client accounts. Whilst buy and sell cashflows can directly affect the underlying assets just like an open-ended fund, they are typically small, reflecting the client base’s significant diversity. There is, however, an obvious risk associated with a company being removed from a wealth managers model portfolio.

So, to a greater or lesser extent, the underlying holding vehicle can sometimes result in significant share transactions that may have little or nothing to do with a business’s fundamentals.

The more diversified the shareholder base and the investment vehicles, the less likely this behaviour will be problematic. The more concentrated the shareholder list, no matter how long-term and committed those shareholders may appear to be, the greater the risk of increased share price volatility due to liquidity mismatches.

Covid, the GFC and Woodford – the impact on investment managers

The Global Financial Crisis, the collapse of Neil Woodfords’ open-ended Equity Income Fund and the Covid-19 pandemic all highlight the significant volatility caused when a fund cannot sell assets fast enough to meet investor redemption requests.

During the GFC and the Covid-19 crisis, most equity and debt funds created enough liquidity to ensure they met redemptions. Even though it may have resulted in significant market impact and could have meant some distortions to the ideal portfolio shape. Due to their assets’ extreme illiquidity, some funds and private equity vehicles were forced to exercise their ‘gate’ provisions to stop a run on their funds. A gate provision is where limits are placed on investor fund withdrawals.  The halt of trading in many open-ended property funds at the height of the Covid-19 pandemic was the most recent example.

The Woodford Equity Income Fund was probably the most extensive and highest-profile example of the impact of a fund liquidity crisis. The initial strong performance and manager track record attracted both institutional and retail investors. It grew well beyond any ‘sensible’ measure of capacity (the fund size beyond which it becomes difficult to buy and sell shareholdings without significant impact on a fund’s performance).

The fund strategy was to build a relatively concentrated portfolio of investments in large, medium, and small-cap listed equities, with a significant weighting in highly illiquid unlisted equities. Following a prolonged period of underperformance, the fund faced a critical volume of withdrawal requests. The position concentration and the lack of liquidity of many of the underlying assets forced the fund to exercise its gate provision to preserve value. The fund was ultimately wound down and eventually closed in January 2020, resulting in substantial losses to investors.

Industry responses

The most significant change for investment managers has been a sharper focus on the risk and liquidity of the fund’s underlying investments. Both regulators and investors have driven this. Many asset managers have confirmed that this series of events had triggered a tightening of their investment guidelines.

The result has been a long-overdue structural and systematic review and overhaul of risk management and portfolio construction, which directly impacts the acceptable and manageable size of the underlying positions in an investment portfolio.

This has reinforced investment managers incentives to concentrate more equitably on the three factors that drive the sizing of portfolio positions: conviction, risk, and liquidity.

Most fund managers use some form of fundamentally driven methodology for assessing a business’s intrinsic value, allowing them to rank each company on a relative basis based on their levels of conviction.

They then use an internal risk framework to identify the range of possible investment outcomes. The broader the range of outcomes, the higher the perceived risk and the lower the position size should be. If the downside is perceived to be large, then a smaller position limits the portfolio damage. Correspondingly if the upside is considerable, then a smaller position will still result in exceptional returns.

Share price volatility is often used as a proxy for risk but looking to the past to predict the future can be unreliable. Instead, best and worst-case 5-year earnings projections are used as a forward-looking attempt to assess real business risk. The message here is simple, the less risky and volatile the business model is, or is perceived to be, the lower the volatility over time. The lower the volatility, the lower the risk and the greater the flexibility for a portfolio manager to accumulate a more significant position as a percentage of their fund. Subject to liquidity constraints of course.

Various Liquidity metrics are used to identify how easy it is for fund managers to buy and sell their positions. Typically, this assumes a percentage participation rate in all daily share trading. The higher the participation rate, the higher the share price impact and the higher the implicit cost and performance erosion. The specific fund structures outlined above will play a significant part in identifying potential liquidity mismatches and will determine those constraints, as will the equity asset class (small-cap, mega-cap, emerging markets etc.).

Managers of open-ended funds will typically focus on managing the liquidity tail risk of their portfolio. For example, a UK small and mid-cap fund would want to hold no more than 10% of its portfolio in illiquid assets (positions that would take up to 6 months to buy or sell assuming only a 10-20% participation rate in average daily volume). They would also have a full set of analysis and guidelines stating the amount of the portfolio they can liquidate over a defined period ( 1, 10, 20 days etc.). This analysis forms one of the critical inputs that define the ‘overall capacity’ of a strategy, or how big the fund should be allowed to get before trading costs destroy some or all the performance generated.

The final factor to consider here is the impact of outperformance or the unintended consequences of significant share price appreciation.  If a stock significantly outperforms, it becomes a larger proportion of the portfolio and this has direct implications for risk management. As the share price goes up, the relative size of the position becomes more significant in a total portfolio context. The simple course of action here is to take profits and sell stock to rebalance. This does not reflect a change in conviction; it is merely sensible risk management.

Watch out for ‘stranded’ investors!

All the above assumes perfect planning over many years by both regulators and fund managers, coupled with consistent market risk and volatility levels, all of which we know is not possible. As a result, many portfolio managers hold sub-optimal or high-risk portfolio positions that they would not have bought with perfect foresight and current fund liquidity constraints.

What may look like a large, committed, long-term holder, especially in small and micro-cap stocks, may reflect a ‘stranded’ investor. A position that is too small to have a meaningful impact on overall performance and too illiquid to be sold or added to. To compound matters, if the position sits in a vehicle that might be prone to large drawdowns, it can be a potential ticking time bomb for the stock price performance.

Tools to help companies identifying and mitigate risks

A successful company has a supportive and well-matched investor base and is able to communicate and predict the range of potential investment outcomes with some degree of certainty. Companies can achieve this by engaging in 3 key initiatives.

1. Perception Studies (Ask)

A perception study is a powerful tool that helps companies better understand the market and investor attitudes towards the three investment factors: Conviction, Risk and Liquidity. It involves gathering comprehensive, detailed, attributable feedback from current shareholders, potential investors and sell-side analysts, providing a window into the perceived investment drivers and sentiment and giving crucial insights into the degree of alignment between the investor’s and company’s expectations.

Importantly, for many small and mid-cap companies, these studies also allow companies to understand the investors’ fund structures and any associated liquidity constraints that might become a critical factor in the magnitude of their shareholding. It will also highlight the degree to which some investors may be ‘stranded’.

2. Investor Targeting (Focus)

By implementing a more systematic quantitively driven investor targeting approach, it is possible to:

• Use data to better match the investment characteristics of a company with a fund’s investment goals and criteria more accurately.
• Identify where a company’s investment characteristics may be diverging from a fund managers’ criteria. This could provide an early warning for an imminent portfolio mismatch that might trigger the need to adjust a portfolio position.

3. Education and communication (Guide)

The principal goal for any investor communications strategy is to ensure that the share price most accurately reflects the company’s fundamental long-term value.

A company with strong financial predictability, good long-term prospects and aligned shareholders can build credibility and may result in an improved valuation and a lower cost of capital.

An effective communications strategy is one that includes a clear understanding of corporate purpose, goals and objectives and a thorough articulation of all of the strategic parts.  These key messages must be crafted carefully and delivered effectively and consistently.