FCA property fund proposals called into question

The financial watchdog revealed yesterday (8 February) that it was probing the fund industry to try to address illiquidity issues in open-ended funds.

Investments in property, infrastructure and unlisted securities have all been singled out in the paper. 

Some of these proposals include introducing a cap on the illiquid assets held within a fund, splitting the investments of institutional and retail investors, and diversifying the investor base of the funds.

This long-awaited consultation comes seven months after the Brexit vote prompted a crisis across commercial property investments, when several funds were forced to suspend trading to stop more cash from being pulled from the vehicles.

The FCA needs to be bold and improve this flawed structure.Michael Morris

Jake Green, regulation partner at law firm Ashurst, suggested many might see these proposals as the "thin end of the wedge".

“I thought it was a bit muddled when the FCA started asking whether there are inherent conflicts between professional and retail investors.

“I wasn’t sure where the FCA was going with this, but I'm slightly worried that we are going to have another layer of fund regulation in the UK that cuts across what people are doing in Europe.”

Mr Green also questioned whether investors will want more regulation, adding many professional investors – who are comfortable with the status-quo and the related risks – might see this as a form of product intervention.

“I would expect the UK to do more to protect the freedom of the professional fund industry.” 

Ben Yearsley, investment director at the Wealth Club, said: “From what I understand, most of the problems of last summer were caused by large institutional investors pulling money out after the Brexit vote.” 

This meant that retail investors were locked into the vehicles because the liquidity of these funds had been drained, which Mr Yearsley described as unfair.

While he agreed there should be something in place to protect retail investors, he said the FCA’s proposal to separate retail and institutional cash was a “non-starter”.

“I don't think separate funds are the answer; retail funds could end up much smaller and institutional funds might end up with a longer lock-up period, neither of which is satisfactory.”

Ryan Hughes, head of fund selection at AJ Bell, said the investment industry has moved to a point where offering daily trading on a fund has become the norm, regardless of the asset class.

He warned that one problem with this is these funds have high levels of cash to offset the liquidity risk, which can increase the cash drag and lead to poorer performance.

“The ideal scenario may be that the FCA, fund management industry and customers accept that offering daily trading in illiquid assets is not the right approach and ultimately not in investors best interests,” Mr Hughes said.

“The trouble is that there is no advantage for any fund manager moving first on this issue; this will only be solved by the FCA taking a strong lead.”

Michael Morris, who manages the Picton Property Income trust, pointed out that it can take weeks or months to buy or sell property, and therefore agreed that daily traded property funds need reviewing.

“The FCA needs to be bold and improve this flawed structure,” he said

Guy Morrell, manager of HSBC’s Global Property fund, which remained open after the European Union referendum, said investors who have exposure to illiquid assets need to be aware of what this means for their portfolios.

Mr Morrell said the problem revolved around investors’ expectations of how quickly they could sell fund holdings in unusual market conditions.  

“Buildings are illiquid and investors need to ensure that prospective returns offer sufficient compensation for this illiquidity,” he said.

Laith Khalaf, senior analyst at Hargreaves Lansdown, said it was sensible that the FCA had ruled out banning open-ended funds from holding illiquid assets.

“This would have been an over-reaction to the problems in the commercial property sector which surfaced last summer.”

However, he said there are no guarantees that the measures set out by the regulator will prevent the same problems resurfacing in future.

For instance, Mr Khalaf pointed out that the proposal to enforce a minimum cash buffer would hamper the long term returns of the fund. 

“It is worthy of note that commercial property funds held high levels of cash in the run up to the European Union referendum, yet this did not stop trading suspensions when the UK electorate pressed the Brexit button.

The Hargreaves analyst also argued commercial property investment is more suited to closed-ended vehicles, and said those who buy open-ended funds must immediately be told about the illiquidity risk.

katherine.denham@ft.com