How to Measure Your Fund’s Liquidity Risk

The amount of level 3 assets, or those that are not actively traded, in a fund is one of the best and most accessible proxies for a fund’s liquidity risk. The difficulty of valuing these assets makes them hard to trade quickly, absent offering them at a steep discount.

Annual reports assign each asset a fund owns into one of three buckets based on fair value accounting standards: level 1, which includes US Treasury bills or equities; level 2, which don’t trade on an exchange but are actively traded (most public fixed income falls here); and level 3, which are not actively traded, so asset managers calculate their fair values using the best information available. Level 3 calculations and their inputs can vary widely.

Morningstar analysts monitor level 3 assets closely because a rising allocation can signal trouble on the horizon. For example, outflows drove Third Avenue Focused Credit’s level 3 assets to 20% in October 2015; the fund halted redemptions in December 2015 and eventually returned what was left to investors. Principal Street High Income Municipal saw its level 3 assets rise from 5.3% in February 2023 to 12.2% by August 2023; later that year, the fund missed the deadline to file its annual report, telling the SEC that it had trouble valuing certain bonds in its portfolio.

Principal Street High Income Municipal was back in the news this summer, this time under a new name, Easterly ROCMuni High Income Municipal Bond RMHIX. The fund lost 29% on June 13 and another 27% on June 16 after heavy outflows. Investors pulled $65 million out of the fund between April 1, 2025, and June 12, 2025.

The fund was able to meet those earlier outflows without notable losses, which indicates it may have sold its most liquid holdings first. But continued outflows would force it to offload its illiquid assets. Those assets take time to trade, time that a mutual fund—which must meet investor redemptions daily—does not have without using a line of credit. But getting a line of credit amid outflows is challenging, and managers may be forced to mark down assets to entice buyers and speed things up. Outflows and losses have cut the fund’s assets from $232 million on April 1, 2025, to $13 million on Oct. 17, 2025.

Gauging level 3 asset totals from annual reports is the easiest way to identify a fund’s liquidity risk. That’s relevant today, given asset managers’ rush to sell private assets to investors on the promise of higher returns. Unfortunately, private assets are less transparent, making it harder for investors to know what they own.

As these private assets enter more and more regulated investment funds (such as exchange-traded funds, mutual funds, and interval funds), asset managers must comply with the expected disclosures, which include a level 3 fair value assessment. For example, Cliffwater Corporate Lending CCLFX, an interval fund, had 94% of its assets in Level 3 as of its most recent annual report. On the other hand, T. Rowe Price Floating Rate PRFRX, a traditional open-end fund, had just 2%.

Given how infrequently private assets are valued, and the difficulty in doing so, most should fall into the level 3 bucket. Liquidity risk isn’t a bug of private markets, it’s a feature, with investors rightly expecting to earn a higher return in exchange for that illiquidity. Having a measure of that risk, even an imperfect one, helps investors set proper expectations for returns and the likelihood of getting their money back. Knowing (what you own) is half the battle.

This article first appeared in the September 2025 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.