The suspension in dealing in the Woodford Equity Income fund has featured heavily in the press for the last month. Mark Carney commented on the situation saying "these funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren't liquid.” The problem is that some funds offer daily liquidity when the underlying holdings are less liquid. The Woodford case once again draws attention to this issue, although it is not a new concern, as many open-ended property funds suspended trading during the financial crisis of 2008/9 and again post the Brexit vote in 2016 when clients wanted to withdraw funds.
The regulator has addressed this by limiting the holdings of unlisted positions in equity funds to 10%. In the case of the Woodford Equity Income fund, the pressure for large redemption requests, on an almost daily basis, caused them to pursue liquidity in more liquid listed positions. As a result, the proportion of illiquid positions breached the limits.
When looking at funds, we are aware that a listing does not guarantee liquidity, especially for a smaller company with a tightly held shareholder register. As such, we attempt to assess the ability and likelihood of a fund being able to meet large redemption orders during normal market conditions, whilst recognising the limitations of this analysis in non-normal market conditions. Similarly, for bonds there may be greater liquidity in high-grade bonds than small issues or loans for lesser credits.
In our analysis, we tend to feel comfortable if the fund has a diversified investor list, which is not prone to 'group think'. We see this as prudent risk management and integral to our fund due diligence. Other red flags include rapid fund assets under management growth in an illiquid space like small cap, all of which help paint a clearer picture on fund liquidity.
Most funds can apply a dilution levy when large investment or redemptions are made to allow for the cost of entry or liquidation of investments in order to protect continuing investors. To an extent, these measures can act as a deterrent to particularly large redemptions; however they have much less effect with an entrenched loss of faith in a manager.
For opportunities to invest in illiquid assets, we favour closed-end investment trust structures rather than open-ended funds. These are 'permanent capital' structures and not subject to the pressure of investor flows on investments. Our view is that although these vehicles are subject to the same liquidity issues of any share traded in the market, they are the preferred route for an investment in an illiquid asset class.
In certain types of investment, it is better to accept restricted liquidity, if the returns are sufficiently attractive and confidence in the manager is high. Liquidity in investment markets has declined since the financial crisis of 2008/9. Regulators have kept a tighter control on banks and reduced their balance sheets, cutting their trading books. As a result, investment banks are providing less liquidity to markets. Thus, in moving to make banks more financially robust, the regulator may be making the investment markets more volatile and as a result less safe for investors.
The effect of the Woodford event is likely to lead to tighter regulation on fund managers to address the liquidity mismatch. Any such regulation will reduce the risk that funds suspend trading when they suffer large withdrawals. It will remain important to continue to carefully examine the risks of liquidity mismatch in open-ended funds.
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