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LIQUIDITY, MUTUAL FUND FLOWS, AND REFLOW MANAGEMENT, LLC Case Solution & Answer

LIQUIDITY, MUTUAL FUND FLOWS, AND REFLOW MANAGEMENT, LLC Case Solution

Introduction

The case is based on the liquidity issues, which arose during the 2008’s financial crisis, leading towards a huge volatility in the mutual funds flow. Madeline Annette was the fund manager at Capital Reserve Fund (a small capitalization fund). Due to the 2008 crisis, the fund’s performance had gotten relatively lower than the industry, which left the manager with no other choice but to maintain the liquidity position for its customers. The investors were shifting their investments from stocks towards risk free assets, such as: Treasury bills, by redeeming their investments form the fund. Being a fund manager, Annette’s responsibilities did not just include maximizing the return and minimizing the risks, but it also included the provision of liquidity to the investors. (Mills, 2009)

In order to maintain the liquidity provision for the investors;the fund’s structure allowed the investors to redeem their share at NAV, i.e. the Net Asset Value. The mutual funds were to be repaid to the investors in cash, within three days of redemption. The fund usually maintained the cash on hand at 3% and if the redemption amount exceeded the cash on hand, then the manager had to fulfill the investors’ redemption by selling the assets and afterwards, if the funds received excess inflow; inflows were then used to repurchase the assets.

Problem Statement

Annette was concerned that the high redemption levels could affect the fund’s portfolio in two ways. First of all, the transaction costs arising from the redemption could increase the fund’s expenses, which tended to decrease the returns for the existing and the outgoing shareholders. Secondly, in order to manage the flow issues; Annette was required to sell the stocks at lower prices, in a down market. Annette had to decide between selling the stocks in a downward market and going for the Re-flow’s services, which might get wasted if the funds flow get settled.

Question 1

Liquidity refers to the ease of the investors, due to which they can sell any asset or security at a market price, without losing its value or it can be defined as the degree to which the investors can sell their assets or securities in the market, which reflects its intrinsic value. (Chen, 2020)

The stock market is different from the real estate market. During a downward trend in the market or economy; the stock market goes down and the real estate market goes up (Nielsen, 2020). It is because during a downward trend; the investor expect the stock prices to fall, which had the potential to decrease their invested value, so they started to shift their investment from riskier assets to the risk free assets, i.e. money market instruments and the real estate market. During difficult market situations; the stock becomes illiquid and the investors would have to sell their stocks at decreased market prices. On the other hand, the real estate is considered as a safe investment and the investors expect the housing prices and rents to rise in the down market trends. This increases the liquidity of houses as compared to a stock, whose liquidity decrease if the market goes down.

Question 2

The two types of liquidity including the market and the accounting liquidity, are relevant to the case.

  • Market Liquidity

The market liquidity refers to an extent to which a market (for instance the stock market) allows the securities or assets to be bought at fair and equivalent prices. In the case, the 2008 global crisis led a downward trend in the stock market, which put pressure on the stock prices. The stock prices fell down because the investors started shifting their investments from stocks to risk less investment options. This situation refers that the stock market became illiquid during the 2008 crisis.

  • Accounting Liquidity

The accounting liquidity refers to the company’s ability of to meet its financial debt obligation using its liquid assets or it can be explained as the ability to pay off the financial obligations as they come due, over time. In LLC’s case, the fund manager was facing accounting liquidity issue, as the fund’s cash on hand was insufficient as compared to the redemption’s by the investors. The market illiquidity led towards accounting illiquidity, as it created redemption’s by the fund’s investors and gave rise to flow issues.

Flight to Quality

Flight to quality refers to a herd like behavior, whereby the investors shift their asset allocation from the risker assets to risk free or safer investments,for instance, in LLC’s case the investor started selling their stocks to put their money in risk free (i.e. T-bills) securities, in order to avoid the financial markets’ uncertainties. The flight to quality can bring an upward or a downward trend in the market. For example: if the investors start shifting form the stock market to bond market, then the stock market will go down as the investors start selling their stocks and the bond market will go up as the investors start buying the bonds…………………

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