Focus on liquidity has increased

Following the EU referendum in 2016, a number of open-ended property funds had to suspend trading for a period of time due to a high number of investors seeking to redeem their holdings.

Similarly, the Woodford Equity Income fund debacle has highlighted how illiquid investments can cause problems for the dealings of funds.

Embattled fund manager Neil Woodford was forced to suspend his Equity Income fund on June 3 after investors pulled around £9m per working day from the fund in May.

The ratio of illiquid and unquoted holdings within the fund prior to its suspension has come under scrutiny as it emerged the fund had broken its 10 per cent permissible threshold twice prior to its suspension.

Liquidity

Scott Gallagher director at Rowley Turton says: “Poor liquidity meant that people couldn’t get their money out as quickly as they wanted and is one of the reasons you should have a diversified portfolio not entirely reliant on any one fund.”

If an investor has an open-ended structure that has a mixture of liquid and illiquid assets, and then the underlying unit holders redeem, inevitably they will only be able to sell liquid assets into the market.

And over time if there continues to be a prolonged series of redemption within the fund, it means that the illiquid assets make up a greater proportion of the portfolio.

For example, in a £100m open-ended fund,£20m is invested in illiquid assets and 80 per cent is invested in liquid assets.

If 40 per cent of the fund is redeemed, the £100m will not be a £60m fund, so the 20 per cent allocation to illiquid assets increases.

Steven Lloyd, Investment Director at Ascot Lloyd says: “If everything is operating ‘normally’ then open ended fund managers are able to sell assets quickly enough to meet investors’ demand for redemptions - they have enough ‘liquidity’.

“However, when open ended funds invest in physical property there can be a ‘mismatch’ when there is a shortage of asset sales to meet redemption

“If this is the case then the fund manager can 'gate' the fund. This is when they didn’t allow investors to withdraw their money. 

“This is exactly what happened with the Woodford Equity Income fund when the investments could not be sold quickly enough to meet consumer demand for money.

"This has brought the liquidity of open ended funds to the forefront of investors’ minds.”

As a result, closed-ended funds are seen as more suited to illiquid assets.

Closed-ended funds are much better vehicles for illiquid assets because the fund and the fund manager can stand aside from the disruptive shorter-term demands of selling those illiquid assets to repay those unit holders who want to exit the fund.

Scott Gallacher director at Rowley Turton says: "For example when the underlying stocks are down, there is no need to hold a damaging fire-sale to satisfy redemptions.

"When stocks are high, there’s no need to dilute performance by buying in extra shares at a premium.

”Also, the fund holders are not at the mercy of the fund manager suspending the fund, that is, they should be able to sell their unit holdings to another investor regardless of the underlying fund position.”

As closed-ended vehicles are companies in which investors buy shares, they do not need to sell assets to meet redemption requests and so are more suited to holding illiquid assets such as physical property, infrastructure or small/unquoted companies. 

“However, care needs to be taken as the liquidity of the fund’s shares should be analysed and these may become illiquid themselves if the trust is very small, for example,” Mr Lloyd cautions.

The FCA is currently undergoing a probe into ACD activities, in the wake of the Woodford Equity Income fund debacle. 

Mr Pursglove says: “I would have thought it is quite right some investigations into the holding of either less liquid or illiquid assets in open ended portfolios, that might for instance, result in some hard lines being out in place or there might be a broader moratorium on illiquid assets being held at all.”

So is there a place for illiquid assets in open-ended structures?

Mr Pursglove says: “The answer is probably, yes, there is a place for them, but the [correct] question is not whether there is a place for them, but at what quantum is there a place for them? 

“The idea of portfolios holding 20 or 30 per cent in illiquid assets which I would not consider to be an acceptable level, but if there is a relatively small exposure to illiquid assets of sub-5 per cent on an allocation, depending on what that asset class is and depending on how liquid the other assets are in it, then they may have a part to play in a portfolio.

“But I would have thought the findings of any investigation will more than likely take a hard line on illiquid assets being held in open-ended funds in general terms.”

Investors should take extra care when investing in illiquid assets via an open-ended vehicle. 

Mr Lloyd says they should ensure that they are taking the illiquidity into account and that their investment horizon is sufficiently long to accommodate this or within a suitability diversified multi asset portfolio. 

He adds: “They should also ensure that they are comfortable that the illiquidity risk is being adequately compensated through additional yield or potential for long term returns.”

ima.jacksonobot@ft.com