Game, set, illiquidity mismatch

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.

When discounts narrowed again and the market recovered, their portfolios had remained intact, generating a healthy yield.

The closed-ended structure’s ability to withstand market turbulence in this way is invaluable when dealing with illiquid assets.

Beyond alternatives

Investment companies’ illiquid investments are not limited to ‘alternative’ sectors.

An increasing number of companies in mainstream equity sectors now have unquoted exposure (see table), with some growth-oriented managers, such as James Anderson and Tom Slater at Scottish Mortgage, finding exciting opportunities among companies that have yet to IPO.

This is not surprising, given that many companies with high growth potential have low requirements for capital and no need to subject themselves to the costs and obligations of the public markets.

Another reason to look beyond quoted equities is that public markets are shrinking.

In key markets such as the US and UK, the number of public companies is in decline, while the remaining companies are older, larger and slower-growing, according to research from private equity investors Pantheon.

In the US, the number of IPOs peaked in 1996 and has been in broad decline since then. It is hard to escape the conclusion that investors who stick to public markets over the next 20 years may have to settle for a narrowing set of opportunities.

In recent years, several investment companies have sought and won shareholder approval to invest more in unquoted companies.

Scottish Mortgage can invest up to 25 per cent, while Baillie Gifford stablemate Edinburgh Worldwide recently uppedits limit from 5 per cent to 15 per cent.

Fidelity China Special Situations and Fidelity Japanese Values have gone from 5 per cent to 10 per cent.

There is nothing new about closed-ended funds investing in private companies. Back in the days when shoulder pads were all the rage and mobile phones looked like bricks, the closed-ended private equity sector was already well established.

It has seen three whole boom-bust cycles and now consists of 18 companies managing £19bn of assets, from diversified mandates such as Pantheon International and Harbourvest, to specialists such as HgCapital and Oakley Capital.

Premium returns

Then, of course, there are venture capital trusts: investment companies that attract certain tax breaks when investors subscribe for new shares.

They invest in young UK businesses, providing them with the capital they need to grow.

The Association of Investment Companies’ latest study suggests that VCT-backed companies make a sizeable contribution to the UK economy, having created 27,000 jobs and paying hundreds of millions of pounds in tax each year.

It would be a shame if the woes of Woodford Equity Income reinforced a perception that illiquid equals bad.

Academic research has shown that less liquid companies produce premium returns: according to a 2013 study from Yale School of Management, annual returns from the least liquid quartile of US-listed companies have been double those of the most liquid quartile over a 30-year period (14.5 per cent versus 7.2 per cent).

Similar results are found among large, medium, small and micro companies: within each group, the less liquid tend to outperform.

The study considers the evidence to be so strong that it proposes liquidity should be regarded as an investment factor, alongside size, momentum and value.

Common sense supports the evidence

Illiquid investments should produce premium returns, for the simple reason that many investors cannot or will not hold them. That implies lower valuations and a boost to returns if assets become more liquid over time.

But there is a problem with illiquid assets too: they are illiquid.

Being a forced seller is painful.

The closed-ended structure removes this risk, while the open-ended one, however modified, leaves it hanging over managers’ heads. That can never be in investors’ interests.

Key Points

• The IA’s new long-term asset fund is designed to accommodate illiquid assets by delaying redemptions.
• The closed-ended fund structure works well for illiquid assets, as the manager does not have to sell assets or suspend trading.
• As public markets continue to shrink, investment trusts have the ability to look beyond quoted equities.

Investment companies with quoted exposure

Source: AIC, June 16 2019

Nick Britton is head of intermediary communications at the Association of Investment Companies