Redemption gates as a standard tool for managing fund liquidity
While gate provisions were previously used only selectively to collective investment schemes or funds with more illiquid investments, the trend is now moving toward using them in the case of liquid investments as well.
Managing liquidity risks is an important aspect of fund management. In this context, there are measures that relate to the portfolio structure and those that relate to redemption procedures. Redemption gates fall under the latter.
Gate provisions restrict the redemption of fund units. The fund contract places an upper limit on redemption volume, either as a relative percentage of the fund volume or as an absolute value. If the upper limit is exceeded, the excess amount can be deferred until the next possible redemption date. In that case, the investors will receive the value of the requested redemption pro rata.
Protecting investors in collective investment schemes
It is important to note that gate provisions are not automatically triggered when the specified limit is exceeded. They kick in only if the necessary market transactions cannot be executed at "acceptable" transaction costs. As a rule, redemption gates are used accordingly as a liquidity management tool only in individual cases or exceptional situations with the aim of protecting investors.
In principle, every fund – including those with liquid investments – can experience situations like that. For example, a relatively large number of redemptions may be requested at the same time, or a redemption volume that can normally be handled at a reasonable cost encounters a market with considerably more sellers than buyers. In such situations, the availability of redemption gates has clear benefits for investors.
Transparent rules in case of liquidity bottlenecks
Precautions such as single swing pricing are not always adequate in an exceptional situation with very high transaction costs. Gate provisions in this context can be referred to as "tail risk hedging." However, it is important for the necessary measures to be stipulated in good time. Implementing them in a stress situation is impossible because doing so requires amending the contract.
That is why fund management companies typically resort to deferring calculation and payment of the net asset value (NAV) to protect investors in such cases. However, this measure usually comes as a surprise, unlike gate provisions, which are transparently described in the fund contract as part of regular redemption procedures. Furthermore, when a fund comes with gate provisions, investors can at least get back a portion of their capital during a liquidity shortage and reinvest it, something that is not possible in the case of a deferral. Compared to NAV deferral, redemption gates have greater advantages when it comes to providing all investors with the best possible protection from depreciating value caused by redemptions while also providing them with fair liquidity in line with the market.
Redemption gates as a standard solution – a plus for investors
Despite the advantages, many investors are still rather critical of the use of gate provisions. After all, they are currently considered an indicator of a fund's potential liquidity problems. This is one reason why the tool has so far only been used very selectively, for illiquid investments in particular.
In general, however, any fund can experience a situation in which there is insufficient liquidity, even if it invests in generally liquid investments. It therefore makes sense to provide for gating for all funds, i.e. also for liquid funds. As a positive side effect, the tool will be perceived as a standard by investors and the liquidity of a fund will again be assessed in a differentiated manner.
Effective liquidity management in collective investment schemes
In summary, redemption gates are a proven and effective means of protecting investors from potential losses in the event of liquidity shortages. All funds can experience a liquidity bottleneck, even if they invest in generally liquid investments. Redemption gates are triggered selectively and only when necessary to protect investors from losses. It therefore makes sense to incorporate gate provisions into all fund contracts. Doing so gives fund management companies an additional tool that is especially effective in extraordinary stress situations. Such measures are entirely in the interest of effective investor protection.
