A senior member of one of Canada's largest regulators voiced concerns about new potential risks that could be lying beneath the surface of financial markets at the Investment Funds Institute of Canada's (IFIC) annual leadership conference in Toronto on Wednesday. 

Specifically, liquidity concerns relating to fixed-income funds, the increasing volatility of standard investment fund portfolios and the potential systemic impact of passive index investing, which has been boosted by the growing popularity of ETFs, are on the radar of Quebec's Autorité des marchés financiers (AMF), said Hugo Lacroix, the regulator's senior director of investment funds.

"These three trends are on our radar," Lacroix told the audience, adding that the investment industry may be entering "the year of liquidity risk management."

AMF research has found the average credit quality of bonds held in fixed-income investment funds has fallen compared with a few years ago, Lacroix said. At the same time, liquidity, or the ability to easily trade those bonds in an efficiently priced market, has declined, as has the cash levels in these funds.

In this current era of low interest rates, many bond portfolio managers have been adding lower-rated bonds, including corporate bonds to their portfolios, spurred by their higher yields relative to high-rated federal government bonds. But if there were a bond market sell-off or sudden rush among investors to redeem units from these fixed-income mutual funds, the low level of liquidity could make it difficult for fund managers to sell holdings and raise cash to meet redemptions.

"Some fixed-income mutual funds could potentially be vulnerable to liquidity risk in the face of financial and economic stress," Lacroix said.  "We did some research and there's blunt evidence of that."

Fixed-income investment funds currently hold 20% of outstanding Canadian bonds, Lacroix noted. Credit quality has declined not only in funds labelled as "high yield," but in regular bond funds as well, he added. Cash levels have also fallen.

"The trend is true for every segment of fixed-income funds in Canada," Lacroix said. "Even plain vanilla funds have seen their credit quality reduced."

Product providers' liquidity management process is a concern, said Lacroix, who questions whether the disclosure of risk has kept up with the change in quality and liquidity.

"Risk disclosure must be full, true and plain," he said. "If there has been a change in risk, then disclosure should evolve too. Products have the same names, but the actual portfolios have evolved over time. Are investors aware? That's an important discussion we want to have."

If the AMF can be convinced that the distribution channel is fully aware of these funds' liquidity risks and is imparting this information to clients, the regulator would be happy to take a flexible, principles-based approach to disclosure that can be customized for each fund, Lacroix said.

"If we don't see evidence that the flexible, principles-based approach is working, then we will have to move to a granular, prescriptive approach," he said, adding that this across-the-board standard wouldn't be as flexible or as tailored to individual funds.

There may be some fear of highlighting these risks in fund prospectuses for fear of scaring investors away, he suggested, but the industry needs to talk bluntly about the real liquidity issues investors face.

Among other concerns, Lacroix also raised the question of whether the rise of passive investing could reach a critical mass in which it would be disruptive to financial markets and contribute to a bubble. Although there's lack of proof that this is premise is true, the question needs to be asked, he said.

Several speakers at the IFIC conference questioned the definition of what passive investing actually is. With some products such as ETFs focusing on factor-based or strategic beta strategies, or providing specific geographical or sectoral exposure, doubts were raised about whether those ETFs represent passive indexing.

Even a portfolio manager's decision to buy an ETF or mutual fund focusing solely on a traditional, market capitalization weighted index could be considered an "active" allocation strategy based on his or her desired equities exposure, added Alan Green, director and head of Toronto-based Blackrock Asset Management Canada Ltd.'s iShares capital markets division.

"Every decision made in investing is active," said Green, who participated in a panel discussion on active vs passive strategies at the conference. "Globally, we're seeing a seismic shift in how active management is manifesting itself."

For example, portfolio managers are making an "active decision" when they choose between an index-based product based on the S&P/TSX 60 index or the S&P/TSX composite index, he noted. They're also making active decisions when they use index-based products such as ETFs to make asset allocations between bonds and stocks, or even between corporate and government bonds.

Added Bruce Sellery, business journalist and moderator of the active vs passive panel: "The boundaries blur when you can actively trade a passive product."

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