Closed ended  

Game, set, illiquidity mismatch

Game, set, illiquidity mismatch

Open-ended funds investing in illiquid assets always remind me of writer Samuel Johnson’s quip about dogs standing on their hind legs: it is not done well, but you are surprised to find it done at all. 

Few open-ended funds have any illiquid exposure, with direct property being the obvious exception.

In this case, the round peg is jammed into the square hole with the help of large cash buffers and trading suspensions when times get tough.

The appeal of this approach seems to be diminishing, with recent research by Financial Adviser’s sister publication Asset Allocator suggesting that a majority of property exposure in discretionary fund managers’ model portfolios is now obtained through closed-ended funds.

Meanwhile, the problems suffered by the Woodford Equity Income fund show that even putting a 10 per cent cap on open-ended funds’ exposure to illiquid assets does not always prevent a liquidity crunch.

In fact, any level of exposure to illiquidity can be problematic.

New structure, same problems?

Undeterred by this, the Investment Association has just proposed a new open-ended fund structure that would attempt to accommodate illiquid assets by delaying redemptions, perhaps by one to three months.

This latest attempt to square the circle – known as the long-term asset fund or LTAF – does not change the fundamental problem of the liquidity mismatch.

For really illiquid assets, such as unquoted companies or direct property, a redemption window of a month or even three offers no guarantee of an orderly disposal in a sustained downturn, while investors may find themselves locked in for even longer than they expect.

You have to marvel at the industry’s determination to make the open-ended structure do what it is manifestly bad at.

It is like trying to invent a non-circular wheel, or fashion an internal combustion engine out of cheese.

Why bother, when the closed-ended fund or investment company is purpose-built for illiquid assets.

In fact, more than a third of investment company assets (£65bn) are invested in the likes of property, infrastructure, private equity and debt. There is no need to force that dog to get up on its back legs when it can run along on all fours as nature intended.

The reason the closed-ended fund works so well for illiquid assets is obvious, but important: no closed-ended fund manager has to sell assets because investors sell their shares, or suspend trading because they cannot sell assets.

Instead, when confidence collapses, it is the share price that takes the hit.

We do not need to think back very far for an example. In the immediate aftermath of the EU referendum, open-ended property funds were forced to suspend trading or break the link between price and net asset value by imposing ‘fair value adjustments’.

Meanwhile, discounts of closed-ended UK property funds widened to double digits.

But while the open-ended funds were lining up properties for sale, the closed-ended fund managers did not have to sell a single building.