Friday HighlightAug 23 2019

Closed-ended funds work for illiquid assets

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Closed-ended funds work for illiquid assets

Recent events have exposed some of the weaknesses of the open-ended fund structure

Investors trapped in gated funds are understanding for perhaps the first time the inherent risks involved in gaining exposure to illiquid assets via an Oeic, and realising that they are not the one-size-fits-all option that many took them for. 

Oeics are certainly a straightforward way to gain exposure to a pool of diverse assets, and offer a host of benefits to investors.

Investor appetite for access to these illiquid assets has soared in recent years.

However, when it comes to more illiquid holdings they have been revealed to be an unsuitable, even a high-risk option, for investors looking for exposure to alternative asset classes such as real estate and infrastructure.

Illiquid assets

Investor appetite for access to these illiquid assets has soared in recent years.

This has been prompted by the ‘hunt for yield’ in an age of rock-bottom interest rates and the whole-of-market investment approach adopted by IFAs following the Retail Distribution Review (RDR).

Attracted by high yields, more investors are diversifying their portfolios away from the traditional asset classes such as bonds and equities, and into alternative investments.

The pursuit of performance is a well-understood objective and a key push factor in the growth of alternative assets.

However, increasing interest in more esoteric asset classes means it has become all the more important to understand how to choose the best structure with which to gain exposure.

As we have witnessed over the past few years, traditional Oeics which invest in illiquid asset classes may have to resort to locking investors out of the fund when they struggle to raise cash to meet investor redemptions.

This is because it is far harder to sell, or ‘liquidate’, holdings in assets such as property, or infrastructure debt, quickly.

The alternative - holding large cash balances to satisfy investor redemptions - results in a ‘cash-drag’ on investment returns.

The closed-ended investment trust structure avoids the need for either of these approaches to the management of liquidity entirely.

There are basic differences between how investor supply and demand is managed in the two structures.

Open-ended funds satisfy investor demand by simply creating more units, and sellers are accommodated through the cancellation of units.

This can be disruptive for investment managers who need to be continually rebalancing the fund portfolio.

Such rebalancing is relatively simple for a deeply liquid portfolio of large cap equities as they are easily traded, and generally in demand, on public markets.

However, as gating and suspensions on open-ended funds have shown, rebalancing a portfolio comprised of less liquid assets presents its own challenges.

With the gating of property funds in the aftermath of the 2016 Brexit referendum, fund managers were faced with a hugely difficult choice.

Do they choose to dispose of properties to fund selling investors’ redemption requests?

Hold substantial cash balances with the resultant drag on performance?

Or suspend selling requests completely, thereby denying investors access to their cash?

As we have seen in recent months, the latter option is not received warmly by investors and raises yet more issues of its own. 

Closed-ended investment companies

This is where the benefits of listed closed ended investment companies – including investment trusts – really stand out.

The closed-ended structure means investment companies provide daily liquidity at all times to their shareholders through a live price on the London Stock Exchange, in the same way as any listed share.

Investment managers in closed-ended funds are encouraged to focus on running a long-term portfolio to secure superior returns rather than the provision of short-term liquidity, and performance does not suffer because of a manager’s over-zealous cash buffer.

Investors are also able to obtain access to a wide range of investment asset classes without the fear of being unable to access their cash.

Sectors such as student residential accommodation, real estate and infrastructure debt are far more accessible via a closed-ended structure, with the assurance that your money is being put to work by investing, rather than being held in cash on the chance redemptions are made.

For income investors, accessing more esoteric asset classes via an investment trust can also be a more secure way to ensure a stream of dependable, long-term returns.

Trusts are able to accrue revenue reserves of up to 15 per cent of the portfolio income every year which helps preserve cash reserves.

It means that dividend payments can be maintained, and even grown, year-on-year even where there are dividend cuts in the underlying portfolio holdings.

Trusts can also make use of borrowings to boost income returns for investors.

The Oeic structure may have been held up as the ‘best’ and most easy-to-comprehend form of collective investing, with its popularity far outstripping the closed-ended space in terms of available products, but it faces big limitations when it comes to esoteric asset classes.

However, the tide may be turning with the number of investment companies entering the alternative space booming in recent years.

According to the Association of Investment Companies, the amount of money held in trusts specialising in alternatives has increased by 92 per cent since 2014, with assets growing from £39.5bn to £75.9bn in 2019.

This is a positive development, driven by the demand for the sector from investors, and bolstered by the knowledge that they are the most suitable structure in which to hold a portfolio of illiquid assets. 

Nick Barker is a director and co-lead manager at GCP Student