When we research collective investments for clients we more often see them as equities. But remember that there are at least two layers of information that we need to investigate: the structure of the wrapper itself (whether it is open- or closed-ended), and the types of investments held inside the underlying portfolio (the mix of debt and equity-type investments).
We often naturally assume that all the funds we are researching can be bought and sold at will, but many of us will recall the times when trading in open-ended property funds was suspended and investors were temporarily stuck; we also recall the split capital investment trust troubles, when a dozen or so collapsed with close to zero value and this affected the underlying values of many others. So it is important for us to understand some of the terms surrounding this area.
Terms of the trade
Liquidity basically describes the ease with which an asset can be quickly bought or sold in a market without affecting its price significantly. We all know that when we want to buy an Oeic or unit trust, in effect we buy directly from the fund manager, even if via a wrapper such as an Isa; and we know that the fund manager will create enough shares or units for us to buy, assuming not enough shares are being redeemed at that time. As long as that fund remains open to new business, the manager is obliged to create those shares or units for you if you want to buy into it.
Open and closed ended
The price you pay is roughly the net asset value, so the fund and the number of shares or units will expand and contract depending on the balance of buyers and sellers; for that reason it is said to be open-ended. Conversely, if you want to dispose of your holding you go back to the manager and they will redeem it.
Closed-ended companies, such as investment trusts, are slightly different. Remember that they are LSE-listed companies, so if you wanted to buy shares in that company, you would instruct a suitable broker (via a wrap platform, for example) to purchase the shares for you. The price you pay, as with any traded security, depends on the balance between the demand for those shares and their availability in the market. So it is not directly linked to the value of the underlying assets, as Oeic prices are.
The price you pay
The price of the shares is affected by many factors – one being market sentiment, which will be shaped by investors’ views on the prospects for the sector in which it is invested, and by the likelihood of the fund’s management adding value compared with its peers. It is therefore apparent that there may be times when some commentators will describe such funds as having poor liquidity. This could mean that there may not be enough willing sellers at the market price.
So what about exchange-traded funds (ETFs)? The position here depends on their structure. Many are Sicavs, open-ended but stockmarket-listed entities. Their managers will create and cancel shares depending on the number of buyers and sellers in the market, to keep the fund flows as stable as possible. In this case, when you buy an ETF you will pay the prevailing market price. ETFs can have different structures and some are open-ended. So it is important to check the structure to understand what applies.
Other factors
We should also consider market liquidity. This refers to the extent to which a market, such as an individual country’s stockmarket or a city’s property market, allows assets to be bought and sold at a price that participants are willing to trade. In general terms, cash is the most liquid asset, while property, fine art and collectibles are all relatively illiquid. We should also factor in the costs of trading to see if it’s financially viable to trade a particular asset; for example, if it costs me 5 per cent to buy a property and 3 per cent to sell it, I might be inclined to steer away from trading. Conversely, if I can trade shares at low spreads I can afford to do that more frequently.
Inside the portfolio
We now need to understand what types of assets are inside the underlying portfolio for these types of funds, and how liquid or illiquid they might be. The nature of these assets depends on the individual fund’s investment objective. But generally speaking, collective funds will have a mixture selected from listed and unlisted global and UK equities, property (both property shares and possibly physical property itself), debt investments such as fixed-interest securities and other instruments, such as derivatives.
You would want to know the percentage of each, so that you could assess the impact on a client’s overall asset allocation when you are analysing their entire portfolio against their risk capacity (how much risk they can afford to take), tolerance (how much they are psychologically willing to take) and need (how much they need to take to meet their objectives). Moreover, the exposure to unlisted equities, and physical property in particular, will indicate the extent to which the portfolio is illiquid.
Asset allocation
Some funds, for example, will prefer to hold property shares rather than physical property for their greater liquidity. However, from an asset allocation perspective remember that property shares are just that – shares; so they will have some of the characteristics of equity, not just of property, particularly in the short term. Some unquoted investments are valued quarterly or half-yearly using accounting rules, although others may only be valued annually. In any case, the accounting value is of little consequence unless a counterparty is willing to trade at that price. As with any unlisted asset, it is only worth what someone else is prepared to pay for it, and that may not be the value indicated in the accounts.
Gearing
Gearing may also have an impact on the underlying liquidity of a closed-ended fund in certain situations, because it will magnify both gains and losses in the underlying portfolio. In times of a sudden downturn in markets, gearing is carefully monitored against the banking covenant (the rules put in place by the lender to ensure there are always enough assets to cover the loan). In tough market conditions in the past it was well documented that some funds whose debt-to-equity ratio approached their covenant limit too closely would sell some of their more liquid underlying assets to repay some of the debt.
ETF variations
Various types of ETFs are available in the market now. Some are index trackers but others are actively managed. For those that track an index, it is important to establish whether they fully or partially replicate their stated index, and whether they use physical or synthetic replication. With physically replicated funds, the fund manager is actually buying those shares and assets (such as gold) listed in the index in the same weighting; with synthetic replication, the manager enters into a swap contract with an investment bank that agrees to pay the index return in exchange for a small fee and any returns on collateral held in the ETF portfolio. So explore the pros and cons of each type of ETF, as specific types may suit particular clients.
It is important from a client’s viewpoint that they do not find themselves in a position where they are forced to sell an asset, whatever that might be. Being forced to sell something quickly invariably means that the price achieved is unlikely to be as favourable as might be obtained by a patient trader. The same applies to a fund manager.
