Bank of England proposals to address liquidity mismatch between open-ended funds and the underlying assets they invest in mean investors would face the “unpalatable” choice of being locked into a fund or redeeming based on fire sale prices.
The central bank’s financial stability report for December raised concerns that current redemption pricing and terms encourage first mover advantage in funds that hold illiquid assets, such as property or unquoted companies.
Globally, there is $30trn worth of open-ended funds with regular redemption terms investing in “longer-dated and potentially illiquid assets”, the report noted. In the UK, 95% of open-ended funds offer daily dealing.
It proposed a “vertical slice” is used to either price a fund unit, based on the prices able to be achieved in one day, or to establish redemption terms based on how long it would take to sell assets that are representative of the portfolio of holdings.
The Bank of England launched the open-ended fund review in July and final proposals will be published next summer. It follows Financial Conduct Authority rules, announced in October, that would require non-Ucits retail schemes (Nurs) to suspend trading when there is “material uncertainty” about the valuation of more than 20% of their assets.
Lock in or fire sale
While the proposals are meant to address systemic risks to the financial system, Interactive Investor head of investment Rebecca O’Keeffe argued the policy proposals create an “unpalatable” choice for fund investors.
“These proposals essentially give investors a choice between a lock in and a fire sale – or at least that’s how it looks to us,” O’Keefe said.
But GBI2 managing director Graham Bentley described daily dealing on funds with illiquid underlying assets as “bonkers”.
“And given collectives are about investing for the longer-term and not trading, that’s even less reason to have daily dealing as standard,” Bentley said. “Longer notice would allow managers to manage cash flow better and get a better price for illiquids. That might reduce trading costs too so everyone is better off.”
The financial stability risks of liquidity mismatch in funds
The Bank of England’s primary concern is the financial stability risks of liquidity mismatch with the central bank perceiving a first mover advantage for funds that hold assets across the liquidity spectrum.
“Although prompt and consistent suspensions are important to ensure fairness to investors and to avoid fire sales of assets, fear of future suspension can further reinforce the incentive for investors to redeem,” the financial stability report said.
Willis Owen head of personal investing Adrian Lowcock wasn’t concerned this reflected the behaviour of fund investors. “In times of stress the behaviour is much more basic. It is self-preservation, although there is clearly an advantage to being first in the queue.”
Investment trusts offer a better alternative
The closed-ended structure of investment trusts already provides a solution to the Bank of England’s concerns, said Lowcock, because they offer liquidity, price transparency, a functioning discount mechanism and daily dealing.
O’Keeffe also wished the Bank of England had acknowledged the closed-ended structure.
“This strikes us as a missed opportunity, given that there is a superior structure for illiquid assets already in place – and it’s called an investment trust,” she said. “No lock in, and no fire sale. The share price may still come under pressure in a distressed market, and discounts will widen – but that gives a potentially attractive entry point for contrarian investors.”
Association of Investment Companies chief executive Ian Sayers pointed to the benefits from a financial stability perspective stating they allow fund managers to take a “truly long-term view” on illiquid assets.
“Investment company managers do not have to manage the portfolio to meet redemptions and so there is no pressure for a fire sale,” Sayers said.
‘Vertical slice’ pricing on fund will be difficult to calculate
The Bank of England sought inspiration from the US Securities and Exchange Commission when it came to measuring liquidity in funds via a “vertical slice” of fund assets.
But Lowcock thought this would be complicated to execute and explain, questioning how a fair price would be calculated for large illiquid assets like property or infrastructure.
“Likewise, introducing funds with different trading rules will just make the investment market confusing especially because in stress periods it is hard to know how long it will take to liquidate an investment – and as we have seen this year it often takes longer than one anticipates,” he said. “The more complex the rules, the greater the impact it will have on private retail investors, potentially putting many new investors off.”
