Asset AllocatorJan 30 2020

UK small caps off the menu as thirst for liquidity grows; DFMs' new Aim anxiety

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Small comfort

Yesterday we discussed the way in which illiquidity issues would linger long after the headline drama's faded from view. Much of this impact will be hard to measure: such is the nature of reputational risk. But there are growing signs that change is occurring at an investment level, too.

From DFMs’ perspective, the most obvious piece of evidence is a shift in their own habits. Liquidity risk was far from ignored by fund buyers prior to the events of June 2019. But most wealth managers took the opportunity to request updated information, and more, from fund providers over the summer. 

Their findings would have been relatively reassuring: Neil Woodford’s penchant for holding unlisted stocks in an open-ended vehicle was not shared by the vast majority of his peers. While Invesco’s Mark Barnett has come under renewed scrutiny, others have removed all trace of their unlisted positions.

But it’s not just unquoted holdings that have caused concern. Anecdotally, it's clear Mr Barnett is not alone in cutting back on small-cap equities. Many are conscious that liquidity levels in listed equities aren’t all they’re cracked up to be, either.

Concerns about the ability to buy and sell small caps have lingered for several years now, but the events of 2019 have clearly focused minds somewhat. Numis has seen evidence of similar behaviours. Its analysts wrote last earlier this month: 

We believe H2 2019 saw a significant number of UK equity managers selling illiquid holdings, partly in response to a letter on liquidity risk from the FCA, particularly through sales of UK small caps.

As they point out, there's a risk that boosting liquidity will come at the expense of alpha generation. Discretionaries are already pretty averse to holding dedicated third-party small-cap funds; if multi-cap funds remove their exposure there will be new asset allocation questions to ask. Accordingly, next week we’ll be taking a closer look at how funds' UK equity allocations have changed over the past year.

Tax test

One smaller part of the market with which DFMs are pretty happy is Aim stocks. Indeed, the rise of Aim-focused portfolios has helped make many of these companies bigger than ever before. 

At the same time, however, wealth managers will be conscious that profound changes to the market could be drawing nearer. The warning signs were there last year, when the Office for Tax Simplification called into question the spirit of Aim tax reliefs.

Needless to say, those reliefs play a big part in the popularity of discretionaries’ Aim portfolios. The OTS report, in and of itself, did not signal change was necessarily on the way. But yesterday saw the publication of another series of proposed inheritance tax changes. A cross-party group of MPs have gone further than the OTS in calling for a complete overhaul of IHT.

This study didn’t give as much focus to Aim investment, but its overall recommendations are just as significant: business property relief and other Aim incentives are in the crosshairs. 

The lesson from the repeated calls for reform to pension tax relief is that these shifts often fail to materialise. But with big things expected from a new government and new chancellor in the Budget on March 11, a major move of this kind is more likely than it once was.

Wealth managers’ background in both idiosyncratic stock picking and tax planning has made these portfolios look like a natural match for their businesses. At a time when competitive pressures are on the march, the industry will be hoping these proposals will remain strictly theoretical.

Bank hold-up

The Bank of England interest rate decision today was trailed as being a ‘knife-edge’ call. In the event, the MPC has voted 7-2 in favour of holding rates. That looks like a sensible decision.

The concern was that the BoE may have boxed itself into a corner last year by indicating its readiness to cut. As the BoE indicated today, sentiment has improved since then, though it’s not yet clear if underlying data will have shifted, too. 

Tomorrow, of course, the UK leaves the EU - and if that does prompt a downturn, however serious, it would be better to keep powder dry. The Bank has avoided repeating the events of August 2016, when rates were seemingly cut on a pre-emptive basis. Incoming governor Andrew Bailey may find himself having to take action in the coming months - but he will at least have a free hand to do so.