Investors could be unable to get their cash from open-ended funds at short notice without taking a financial hit under new proposals floated by the Bank of England and the City-watchdog.
In a joint financial stability report, published yesterday (December 16), the BoE and the Financial Conduct Authority said there was a “mismatch” between redemption terms and funds’ liquidity which led to unfair advantages for investors who redeemed first.
As part of a solution the regulators stated investors pulling their cash should receive a price for their assets which reflected the discount needed to sell the required portion in the specified time period.
For example investors who asked for their assets within 24 hours would receive a lower price for their units compared with investors who gave a longer notice period.
The report stated: “This principle would ensure there was no incentive to redeem from a fund ahead of other investors.
“Selling assets quickly or in large volumes could require funds to accept a discount, particularly in stressed conditions. This could disadvantage the remaining investors in the collective investment scheme.
“To avoid that, redeeming investors should bear the consequences of those discounts.”
According to the BoE and the FCA, swing pricing — which allows the price to be adjusted to reflect potential losses for other investors — was already used by some funds across other jurisdictions.
FCA research showed funds that used swing pricing did not experience significant outflows during periods of low liquidity or market stress.
Other policies suggested by the regulators included a shift in the way the liquidity of the funds were assessed.
According to the paper, a fund’s liquidity should be assessed based on either the price discount needed for a quick sale of a representative sample of the fund (including liquid and illiquid parts) or the time period needed for a sale to avoid a material price discount.
The FCA and BoE said this could create “greater transparency” around fund liquidity and was a “necessary step” to ensure redemption terms were aligned with a fund’s actual liquidity.
Classifying liquidity in this way has already been adopted by the US’ Securities and Exchange Commission. US funds must classify their assets into buckets based on the time period of sale and settlement needed to avoid a price discount.
The proposed changes come after the Financial Policy Committee, part of the BoE, judged that the liquidity mismatch in funds had the potential to become a systemic risk.
The committee thought it could result in amplified asset price moves which “transmitted stress” into other parts of the system, disrupting the availability of finance in the real economy.
The FPC stated: “The issue should be addressed before it grows further or interdependencies between funds and the rest of the financial system become more prominent.”
Problems surrounding illiquid assets in open-ended funds were highlighted twice this year; first with the suspension of the Woodford Equity Income fund and again when M&G gated its property portfolio at the start of December.
Former star-fund manager Neil Woodford was forced to suspend his flagship fund on June 3 when he was unable to meet the requested redemptions.
The fund had been struggling with outflows but Woodford's representatives had played down fears about the fund's liquidity, saying outflows had become moderate and that the fund manager remained as confident as ever his strategy would pay off.
But when Kent County Council asked to pull the £260m it had invested in the fund, the portfolio did not have enough liquidity to meet the redemptions and was suspended.
The M&G Property Portfolio suspended trading for the second time in three years on December 4 as the fund battled to deal with an “unusually high and sustained period of outflows”.
The asset manager said political uncertainty and ongoing structural shifts in the UK retail sector had made it difficult to sell commercial property and therefore meet the requested redemptions.
Previously, in July 2016, the fund was one of a number of open-ended property funds to suspend dealing in the wake of the EU Referendum.
Ryan Hughes, head of active portfolios at investment platform AJ Bell, said: “The proposals set out by the BoE and the FCA make it clear that the current rules are not tough enough and that further measures are required to ensure that fund liquidity does not become a systemic risk.
“The proposals could be interpreted that the use of daily trading for illiquid assets may be coming to an end.”
imogen.tew@ft.com
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