Fund managers who deal in illiquid securities need to stress-test their portfolios for liquidity concerns, fair value securities that are rarely traded and disclose all of this to investors, the Ontario Securities Commission (OSC) says.

The OSC’s Investment Funds and Structured Products Branch issued a report on Thursday detailing the results of a recent compliance review of mutual funds that invest in securities that may lack liquidity, such as small caps.

In 2014, the branch reviewed 22 funds (both mutual funds and exchange-traded funds [ETFs]) that could have bigger concerns about portfolio liquidity — high-yield debt funds, emerging market funds and small-cap equity funds. The review examined the funds’ approach to stress-testing, valuation and identifying illiquid assets.

Most of the funds and their managers had policies in place to deal with these concerns, the report notes. “We found that [fund managers] are generally aware of liquidity risks, and have taken liquidity risks into consideration in their day-to-day management of the funds,” it states.

The review did not uncover any practices that resulted in referrals to enforcement, although the report notes that some of the funds reviewed, notably small-cap funds, did sell off some of their illiquid holdings to ensure that they are in compliance with the mutual fund rules.

Notwithstanding the lack of major issues, the report sets out guidance for the industry on ensuring that fund managers are adequately managing these risks. For example, the OSC recommends that funds have robust written policies on assessing the liquidity of their holdings, both at the time of purchase and on an ongoing basis.

“Being listed on a stock exchange with a quoted price alone, in staff’s view, is not generally sufficient to conclude that a particular holding is liquid,” the report states. “A stock listing does not necessarily mean that an equity investment could be readily disposed at a price that approximates the last market transaction or is within the current bid/ask spread.”

The report also recommends that funds have procedures in place for stress-testing their portfolios to ensure that they can effectively meet redemptions in stressed market conditions.

These tests should include scenarios that exceed funds’ past redemption experience, the OSC says, and funds should also consider stress-testing for portfolio performance alongside portfolio liquidity.

“As liquidity of underlying investments, large redemption requests and stressed market conditions tend to correlate with each other, effective stress testing should take into consideration different market conditions that would affect the performance of the funds,” the report adds.

In addition, the report recommends that funds with higher exposure to potentially illiquid assets provide additional disclosure and ongoing discussion of their risk management policies and investment restrictions that are designed to mitigate liquidity risk.

“We think better risk management discussion provides clarity of the fund’s investment policies and can enhance investor understanding and expectations,” the report states.

The review also found some weaknesses in funds’ valuation practices, notably “closing market values were generally used for equity investments, including small capitalization issuers, without any further consideration of market activity and conditions.”

The report reminds fund managers to refer funds to International Financial Reporting Standards (IFRS) for guidance on determining fair value. It notes that funds utilizing fair value measurements must also make additional disclosure. And it recommends that fund managers obtain standing instructions from their Independent Review Committees about their valuation policies to address the conflicts of interest that can arise when they value illiquid assets.

The report also notes that asset classes that face heightened liquidity concerns will remain a focus for the OSC. It indicates that this represents approximately 12% of total industry assets under management (AUM) — with about 7% of total industry AUM in high-yield global fixed-income funds, 4% in Canadian, U.S. or global small/mid cap funds, and 1% in emerging market equity funds.

“We continue to monitor the development in this area, and will publish more guidance or take other regulatory action as needed,” the report concludes.