Open-ended funds are an important means of investment into illiquid assets, and represent an efficient way for large numbers of people, including retail investors, to get access to those assets.
Open-ended funds are an important means of investment into illiquid assets, and represent an efficient way for large numbers of people, including retail investors, to get access to those assets.
The FCA asked a number of questions about whether and how the mismatch between the frequency of the liquidity opportunities offered to investors (often daily) and the relative illiquidity of the underlying assets might be better addressed.
Professional vs. retail
One question the FCA asked is whether professional and retail investors should be distinguished? In practice, however, the differences between professional and retail investors are more theoretical than real.
Many retail investors have the benefit of expert advice prior to investing, and of course most professional investors (such as discretionary fund managers and pension funds) ultimately represent retail investors at the end of the investment chain.
Suspensions provide space for markets to settle down to a point where price discovery becomes possible again.This spectrum of expertise would suggest that it is not appropriate to direct “retail” and “professional” investors into different funds or share classes. Indeed, distinguishing between retail and professional investors could raise questions about fair treatment of customers.
But consumers, generally, might be better served if they had a range of liquidity options to choose from, and this might also enhance their appreciation of the impact that liquidity frequency has on portfolio composition and cash management.
Enhanced disclosure
The FCA has questioned whether fund disclosures could be enhanced. In actual fact, fund disclosures tend to be very thorough but there is a question mark over whether retail investors, at whom enhanced disclosures would principally be targeted, fully read and understand the disclosures.
However, investment in open-ended funds running illiquid strategies is largely intermediated and one would expect these retail investors to be better-informed than execution-only investors.
Nonetheless, disclosures could be more prominent and could provide more “colour” on the manager’s proposed approach to liquidity management.
For example, would the manager seek to impose longer notice periods or redemption discounts in preference to a suspension? Would they seek to run a larger cash pool in order to minimise the risk of suspension or run a smaller cash pool in order to maximise investors’ exposure to the chosen investment strategy?
Every investment decision made by a manager has an opportunity cost, and more emphasis might be placed on explaining this cost to investors with a view to increasing investor choice.
However, heavily prescribed disclosures would make this type of explanation difficult to give in sufficient detail. It would not be possible to give a clear explanation of the various liquidity options and how they might impact investment decisions within the confines of Key Information Documents (KIDs) to be imposed under the Priips regulation.
While the disclosure would be available in the full prospectus as already noted, there is no way to ensure investors read the full prospectus, rather than the KID or other summary information.
In addition, a good manager will adapt their approach to reflect market developments. This might be challenging in the face of pre contractual disclosures already made.
Use of specific tools
Suspension of redemptions is not the only liquidity tool available to fund managers. However, intermediaries play an increasingly important role in fund sales, and their IT infrastructure puts practical limits on how liquidity management tools can be deployed.
Platforms do not generally support queued or deferred redemptions, but changing this would require significant IT investment - and regulatory intervention would likely be needed in order to justify this investment.
Portfolio structure and liquidity buffer
The decision as to how much liquidity to run in a portfolio depends on a number of factors, including overall portfolio composition, and hard limits are a blunt tool to address liquidity requirements.
Strict limits would also affect the overall returns to investors who are seeking exposure to the headline illiquid strategy, not an uncorrelated set of liquid investments.
The FCA’s Discussion Paper had a working assumption that the quality of a real estate asset determined its liquidity. However, practice has demonstrated this was not a reliable assumption.
Ultimately, provided that pricing is realistic, all assets are liquid – noting that managers have to balance the need to raise cash to fund exiting investors against realising a fair value for continuing investors.
Secondary market provision
Real estate investment trusts (Reits) and other closed-ended structures are arguably better placed to hold illiquid assets. The permanent capital allows the manager to play a long game with respect to investment and divestment decisions. But the listing allows the investor to exit, even in a stressed scenario, albeit at a market-imposed discount.
Nonetheless, Reits are not a panacea and it is important to recognise that investors need a range of investment products, including open-ended products.
While it might be helpful to introduce rules that facilitate the conversion of open-ended funds to closed-ended funds, the concern would be that this would result in widespread redemptions and the need for significant portfolio realignment to accommodate that.
The International Property Securities Exchange (IPSX) is intended to be a new regulated market for trading single commercial real estate assets and to act as a proxy for direct investment in commercial real estate.
The ability to trade shares in single asset vehicles could offer a new source of liquidity to open-ended real estate funds. There is certainly room for a more joined-up approach with HMRC to make it easier to wrap illiquid assets in vehicles with a view to promoting liquidity.
Managing the investor base
Within the industry there is little support for setting caps on the proportion of a fund that can be owned by a single investor. The idea that particular investors might be required to divest part of their holding in a fund seems unreasonable.
However, there is clearly a need for dialogue with investors to understand likely investment and divestment intentions, and to build up an appropriate liquidity profile in response to those discussions.
Asset valuation and anti-dilution measures
There is a perception that suspending redemptions on a fund is akin to a run on a bank, which can trigger unwarranted knee-jerk behaviour. However, in reality suspension of redemptions is about allowing a period of price discovery as much as it is about raising cash to fund redemptions.
In periods of volatility, price discovery is extremely challenging, and suspensions provide space for markets to settle down to a point where price discovery becomes possible again.
Redemption discounts, as opposed to suspensions, allow a manager to adjust the redemption price in order to account for the valuation uncertainty. In the past, imposition of redemption discounts has been criticised on the grounds of the manager seeking to penalise exiting investors, whereas the reality is simply that discounts simply reflect a volatile market.
In terms of the governance process around pricing and valuation, it is the Depositary’s role to engage with the manager on pricing.
In turn, depositaries acknowledge that different fund managers have different approaches to valuation, which is appropriate given that valuations need to reflect the circumstances of particular funds.
Summary
There is room for rule changes in discrete areas. For example, intermediaries such as platforms and transfer agents could be required to make technology changes that facilitate the use of liquidity management tools other than suspension; and rule changes to require more granular disclosures around liquidity management tools might assist with transparency.
On the other hand, regulatory intervention in areas such as portfolio composition or regulator-imposed suspensions, risks taking the responsibility away from those with the expertise and experience to make the relevant decisions.
All industry participants need to work together openly to provide solutions in terms of robust governance, particularly in relation to asset valuations.
The asset management review is about creating trust in the industry and the industry must commit to change and be seen to do so.
More fundamentally, the regulatory approach to liquidity needed to be considered. A requirement for daily liquidity is driven by the regulator and by the tax framework.
But if investors can understand that they lose interest if they withdraw money from a high-interest savings account, surely they can also understand that they will lose returns if they invest in a fund that has to be managed to daily liquidity.
Cathy Pitt is a funds partner with law firm CMS
