Open-ended funds may not always be the most appropriate home for illiquid assets, as any investor stuck in Neil Woodford’s suspended Equity Income fund may tell you.
Before Woodford, another memorable time when UK retail investors experienced this situation first hand and in large numbers was immediately after the EU referendum in June 2016. At the time, a heightened number of investors were looking to flee funds in the UK Direct Property sector, predicting corporations’ exodus from the country, which would lower the value of the funds’ underlying assets.
Fund managers struggled with the high levels of outflows and redemption requests, and several of the sectors’ Oeics suspended trading, temporarily locking investors out of some £15bn of their money.
This caused concern at the FCA and sparked its ongoing consultation on how to cope with a large volume of outflows and redemption requests in funds with assets that were hard to sell quickly, such as property or corporate bonds.
Managers may soon be tested on how well they learned the lessons from that crisis.
With the Brexit saga not yet closed and the outlook as uncertain as ever, investors may be ready yet again to run from funds as the new EU departure date (31 October) approaches. When Brexit day loomed last time (29 March), retail investors proved anxious about UK equities in particular.
The end of 2018 saw another period of sustained outflows from the UK Direct Property sector, with investors withdrawing around £450m during the last three months of the year – just short of the £465m-worth of outflows that hit the sector during the June 2016 stampede. In the month of December alone, some two-thirds of June 2016’s outflows – or £315m – was withdrawn. This prompted the FCA to put property funds on daily liquidity watch.
In its ongoing consultation, the regulator has made clear that it expects managers to monitor liquidity. With a potentially fractious Brexit outcome looming, managers need to demonstrate their readiness – but suggestions differ on how best to tackle stampedes.
Should we alter prices during market stress?
Last month, a paper written on behalf of the FCA presented a formula for halting redemptions in funds with hard-to-sell assets during market stresses, such as that witnessed three years ago or the one that occurred amid the 2008 credit crunch.
The authors of the paper conclude that adjusting prices to “swing” or “dual” prices can “significantly reduce redemptions during stress market periods” and stop investors fleeing the funds.
According to the report, swing and dual pricing protects the long-term investors in the fund from having to pay the extra cost associated with a sudden surge of outflows. In addition, traditional (“non-adjusting”) pricing models incentivise investors to start a run on the fund – an undesirable effect, especially during times of volatility.
The report concludes: “Alternative pricing rules help funds to retain their investor capital during periods of high market stress.” It endorses adjusting prices as a preferable liquidity management tool to that of suspending trading in funds altogether, or imposing “gates”, under which the manager limits the redemptions.
The aftermath of the Brexit vote saw Standard Life Investments, M&G, Columbia Threadneedle, Aberdeen Asset Management, Janus Henderson and Aviva Investors all impose temporary gates on investors exiting their property funds.
Which customers get treated fairly?
Commenting on the report’s findings, Belmayne Independent Chartered Financial Planners financial planner David Bashforth says: “This research simply goes to confirm what many fund managers have already worked out for themselves: that swing pricing, or at least partial swing pricing, is a fairer way to protect loyal investors than simply employing a share of a net asset value pricing system.”
Bashforth notes that a different model was formerly used by Vanguard Asset Management, namely charging a pre-set dilution levy at outset. He says: “This equated to the costs of dealing into the fund and was a very transparent way of dealing with this issue.”
Bashforth adds: “Vanguard moved to swing pricing, at least in part, because the majority of the market operated on that basis, and having what equated to an initial charge on entry clearly stood out in comparison to peer funds.”
He says that, at the Belmayne in fact, they prefer the original pre-set dilution levy “because of its transparency”.
Bashforth notes: “Now, we have to explain to our clients that, although this charge no longer appears to apply and hence purchased units look cheaper to buy, this is not actually the case and the costs have instead been absorbed into the swing price.”
Opinions differ on what is fair, depending on whether one looks from the perspective of the long-term investor or that of the exiting one.
While the paper puts fairness towards long-term investors at its heart, the FCA’s executive director of strategy and competition, Christopher Woolard, when referring to proposed changes deriving from the regulator’s consultation, said the
FCA hoped that these would result in “reducing complaints from retail investors about perceived unfair treatment when they exit such funds”.
Hearthstone Investments chief executive Cedric Bucher disagrees with the paper’s conclusion of adjusting pricing as a way of mitigating fire sales – that is, when assets are trading at a heavily discounted price.
Bucher says: “The only way to avoid fire sales is a fund suspension. This gives the fund manager time to get the right price for properties or other illiquid assets, by stopping the urgency to generate cash quickly to pay out redeeming investors.”
He adds: “At Hearthstone, we prefer the single swing price policy. It is more intuitive, clearly aligned to the FCA’s Treating Customers Fairly policy, and should have fewer unexpected surprises for investors.”
Moving property to a closed-ended structure
For some, the easiest solution to prevent troubles from fire sales lies in moving property purchases out of the open-ended structure altogether.
Brooks Macdonald deputy chief investment officer Edward Park says there is a fundamental “mismatch” of open-ended collective funds that hold illiquid assets “as their daily dealing structure simply doesn’t match the reality of trading the underlying investments”.
Park adds: “For this reason, within the property fund sector we now exclusively buy closed-ended listed investment vehicles, avoiding the open-ended funds that can experience gating as seen in July 2016.”
Supporting long-term thinking
Apart from adjusting price or gating, managers of open-ended property funds have several other liquidity management tools at their disposal, including holding cash buffers or having prominent disclosures in the funds’ prospectus, warning the retail investor of risks associated with funds that hold hard-to-sell assets.
The adviser’s role in explaining to the client that assets such as property are intended for the long term becomes vital once more.
Bucher says: “What is important is that investors are fully aware this can happen in times of stress, and ensure monies are held in such funds only where there is no need for liquidity in the short term, which really shouldn’t be an issue in the first place.
“Anyone investing in a fund should have at least a three- to five-year investment horizon, otherwise any adviser should recommend that monies are held in cash.”
This Wednesday, just after Money Marketing went to press, asset management trade body the Investment Association was set to announce a new fund structure – a ‘Long-Term Asset fund’ – that would seek to address issues of illiquidity mismatch by limiting when investors could withdraw their money from daily to less frequent periods, encouraging a more long-term view.
Where a liquidity mismatch occurs, there is always the danger that fund managers will be forced to fire-sell assets in order to meet investor redemption requests, although this will almost always never be in the long-term interests of investors and may be strongly to the detriment of long-term investors.
One of the more successful approaches to mitigating this has been for funds to operate on a dual-priced basis where the purchasing investor essentially pays an upfront charge for accessing the assets.
During the post-Brexit referendum period’s property liquidity problems, it was interesting to observe that those funds that had this structure seemed to manage flow far better than those that didn’t. While there may be a number of reasons for this, it certainly appears the case that paying an upfront cost to access the asset focuses the mind in ensuring that only committed, long-term investors are in the fund. As a result, it removes the likelihood of short-term investors/speculators being in the fund, which should create less pressure on the underlying manager.
Personally, my preference is still to move away from daily dealing as a standard approach as it makes investors very aware that they are giving up something to access the liquidity premium.
Ryan Hughes is head of active portfolios at AJ Bell