Investors sceptical FCA LTAF proposal is the panacea for property fund liquidity mismatch

‘It is the investing behaviours that need to change more so than the investment structure’  

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Long-term asset funds (LTAFs) are being pushed by the Financial Conduct Authority as a viable solution to property funds’ liquidity mismatch problem but commentators aren’t sure adding another open-ended structure will make life easier for intermediaries and retail investors.

The regulator announced on Friday it had postponed its decision on implementing notice periods for open-ended property funds until Q3 while it gathered feedback on a new structure, the LTAF.

The LTAF concept was initially developed by the Investment Association in June 2019 as part of a package of reforms proposed to the HMT Asset Management Taskforce.  

Last November it received the backing of chancellor Rishi Sunak, who called on the first LTAFs to be launched within the year to encourage pension funds to pump money into illiquid assets like infrastructure to help fuel Britain’s economic recovery.  

With the consultation still in its early stages, details on the eventual shape of the fund remain sketchy. But the FCA is proposing the fund will embed longer redemption periods, high levels of disclosure and specific liquidity management and governance features.    

Despite the raft of property fund suspensions after the Brexit vote and during the coronavirus pandemic, the City watchdog has settled on an open-ended structure for the LTAF on the basis some investors prefer having the flexibility to take money in and out at the net asset value of the assets. 

See also: FCA needs more time to decide fate of open-ended property funds

Investors may have given up on open-ended property funds before LTAFs shows up

GBI2 managing director Graham Bentley believes the best solution for retail investors would be to have all property funds in an LTAF structure. 

The concept has merit in that it allows retail investors to tap into parts of the market that were previously inaccessible like private equity and infrastructure. 

However, he thinks by the time the first LTAF makes it to market, which will take longer than the chancellor’s time scale, retail investors might already be disillusioned by open-ended property funds. 

Professional investors’ big headache with implementing notice day periods is the impact on automatic rebalancing of model portfolios, a point he says is glossed over in the consultation. 

“From a pure, what happens to property funds point of view, I think you’re going to find a lot of portfolios either shying away from them or having very limited exposure,” says Bentley. And so, by the time LTAFs come in, it might be a moot point.” 

See also: FCA notice period proposals could be the ‘death knell’ for retail property funds

For those who want to keep some brick-and-mortar property exposure in their model portfolios, Bentley thinks they will opt to use a single fund as opposed to two or three.  

“If you’re going to have a variety of different possible notice periods and liquidity in different funds, that makes it even more complex to deal with.” 

LTAFs face same operational challenges as open-ended property funds 

Judging from the FCA’s own proposals LTAFs would need to contain a lock-up period to account for the illiquidity of the underlying assets.  

But this means intermediaries would be saddled with the same problem as they would with an open-ended property fund with a notice period when their client wants their money back, says Ben Mackie, fund manager at Hawksmoor Fund Managers.  

And if an LTAF manager is met with a wave of redemptions at the end of a 90-day or 180-day lock-up periodthey could still find themselves in a situation where they become a forced seller, Mackie adds. 

“The really important thing here is the manager isn’t encumbered by having to manage those flows, and I’m not sure an LTAF fully negates that problem.” 

Why not just use an investment trust? 

Fairview Investing consultant Ben Yearsley also isn’t convinced rolling out a new open-ended fund structure is the answer. 

“I think we have LTAFs, they’re called investment trusts,” he says. You’ve already got LTAFs which work very well for things like property, infrastructure and private equity. Then you’ve got open-ended which works for everything else. Why do you need anything in the middle?” 

Hawksmoor’s multi-asset funds only invest in closed-ended structures for property exposure to avoid the liquidity risks of open-ended funds.  

Though Mackie recognises that trusts are not without risk due to the discount volatility, he says the closed-ended sector fits with Hawksmoor’s preferred granular, targeted approach to property compared to the open-ended sector which tends to be “quite generalist in nature”.

Mackie currently owns three Reits – Urban Logistics, which specialises in “last mile” warehouses, Supermarket Income Reit, which acts a bond proxy, and nursing home owner Impact Healthcare, which benefits from positive supply and demand dynamics.  

See also: DFMs tap investment trusts for income and alternatives during pandemic

Investing behaviours need to change, not the structure 

JB Beckett, independent fund board director and former fund selector, says the LTAF proposal “might” make sense for some Oeic and unit trust property managers. 

Beckett notes a lot of property funds are already non-Ucits retail schemes (Nurs) or unit-linked funds and as such already can manage their dealing frequency, suspension and lock-ins. “The FCA has mis-stepped by making this more difficult for property funds in recent years,” Beckett says.

But any proposed structural changes will be in vain if managers are not able to address the “cavalier attitude” of retail investors. “Daily dealing property always was and still is a misnomer,” Beckett says. “Fractional unitising and divisible ownership don’t get it done.” 

“What we really need now is to change investor and adviser behaviours when using property; through the suitability process and when churning in and out of property funds,” he continues.

“To that end, the new proposal is unlikely to be the hoped panacea until we better educate. It is the investing behaviours that need to change more so than the investment structure.”  

Alternative proposals 

The FCA’s proposal of introducing mandatory notice periods for property funds went down like a lead balloon with only a small number of the 70 respondents to the consultation agreeing this was the best course of action. 

Respondents offered up a range of alternative proposals to address the liquidity mismatch from only applying mandatory notice periods to institutional investors, who typically have a larger pool of assets in each fund, to requiring funds to hold a minimum percentage in cash or a maximum percentage of physical property assets.

In Yearsley’s view the regulator has one of two options – either come up with a notice period for all open-ended property funds or set a limit on physical property exposure 

He thinks there could be more funds adopting the BMO Gam Property Growth & Income model of having a 70/30 brick and mortar/securities split. 

Yearsley and other commentators are adamant that requiring funds to hold higher cash is not a palatable choice for investors.  

“You look at M&G’s proposal that they’re going to hold 20% in cash. I don’t want to be paying fund managers to hold 20% cash in an asset class when I want the whole thing invested.”  

See also: M&G to unfreeze £2bn Property Portfolio after nearly year and a half suspension

Fund managers setting their own redemption periods would be compliance nightmare

Another idea that has been floated is for asset managers to set their redemption periods themselves rather than the regulator doing it for them 

Bentley says this idea looks OK on paper if fund groups agreed to a quid pro quo arrangement whereby if they fail to have enough liquidity at the end of the notice period to redeem holdings, they would be forced to pay for it out of pocket. 

However, in practice he thinks this would quickly devolve into a compliance nightmare.  

“They’d [asset managers] have to think about the competitive benefit, in other words, are they likely to see more assets because they have a 30-day period than somebody who has a 90-day period and is the margin that they gain from that competitive advantage sufficient to take that risk.  

If I was the head of risk in an asset management business I would be very, very suspicious of proposals to use that and the board would probably raise quite a few objections to that approach, and I suspect compliance would do as well. 

The reality is whilst you might have these various options, I think the industry would home in on whatever the regulator said was appropriate, particularly if they didn’t have to stand up for the liquidity themselves. 

Middle ground

A possible workaround is that fund providers could enter an arrangement with a bank to pick up some of the liquidity risk, Bentley suggestsIf a fund manager has the cash to redeem at the end of a 30-day notice period, they would pay a premium to the bank. But if they don’t the bank takes the risk on board and pays out the client on the asset manager’s behalf.   

“One thing this industry is very good at is getting round things,” Bentley says. “One part of the market is thinking, ‘Can we do this the easy way?’ and the other end of the market actually seeks out complexity in order to earn a crust because the majority of people who buy it don’t understand how it works.  

“But there’s a nice halfway house, where fund managers enter into derivative agreements with banks to protect themselves and think it’s worth paying a premium. 

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