How do we prevent another Woodford? To anyone outside the investment industry, it’s a blindingly obvious question. Yet it’s been given scant consideration by the regulator.
The FCA has sidestepped the question by suggesting that investors were warned about the risk of suspension in the prospectus of LF Woodford Equity Income. I’m not sure that telling Mr and Mrs Retail Investor that they should have paid more attention to page 24 of the prospectus is a great look for a body that’s supposed to be protecting consumers, but let’s leave that wholly inadequate response to one side.
Even assuming that people read prospectuses, disclosure can never be the whole answer. When you have an operation, you’re warned that it could go horribly wrong – but that doesn’t mean that your surgeon shouldn’t do everything possible to minimise the risks.
Some have suggested that an outright ban on open-ended funds holding illiquid assets is the answer. At the AIC, we would certainly argue that assets like property and private companies are best held in the closed-ended structure. In fact, we’ve been drawing attention to the dangers of liquidity mismatches for many years. We haven’t been alone, either: Mark Carney’s remark this year that daily-dealing funds holding illiquid assets were “built on a lie” followed several similar (albeit less provocative) comments he has made in the past.
But it’s very unlikely that a ban will be the FCA’s preferred solution. The regulator has commented that it does not want to prevent open-ended funds investing in illiquid assets, as long as investors understand the risks.
The FCA has toyed with the idea of making fund suspensions compulsory for property funds where there is uncertainty over the valuation of 20% of a fund’s portfolio, but they rowed back from this in September. Suspensions will not be mandated if an asset manager and depositary agree they are not in investors’ best interests. This leaves open the option of implementing “fire sales” to deal with redemption requests in difficult market conditions. The FCA has no problem with that, provided that such policies are disclosed to investors.
This normalisation of suspensions and fire sales as “liquidity management tools” is extremely worrying. Not only does it fail to protect consumers, it also does nothing to avoid systemic risks.
IOSCO, the international regulatory forum, says suspensions should only be used in unforeseeable circumstances. The circumstances that led to the suspensions of property funds in 2008 and 2016 were eminently foreseeable.
As for fire sales, these can never be in investors’ best interests. If liquidity mismatches prompt a vicious cycle of asset sales, it will be little consolation to know that the risks were disclosed.
Other financial centres have their eyes on these issues. In Germany, open-ended funds holding property must impose a 12-month notice period for redemptions. The Central Bank of Ireland has just launched a review of fund liquidity rules, citing the dangers of a mismatch between investors’ expectations of liquidity and what is practically possible. If the tide of opinion turns, a review of the Ucits rules that allowed Woodford Equity Income to dabble in unquoted companies is not out of the question.
The AIC is not calling for a ban on illiquid holdings in open-ended funds. But the fund structure, including the redemption terms, must fit the underlying assets. Investors must be able to put their trust in redemption terms, both in normal market conditions and (crucially) those that are not normal, but foreseeable.
The principle of “reliable redemption” is that the basis on which an investor can leave a fund should not change, whatever the level of redemptions. Liquidity management processes should not leave open the possibility of fire sales, but ensure that assets can be sold in an orderly market.
It’s a simple and proportionate measure that would not just protect retail investors, but institutions too (Kent County Council) as well as the integrity of the wider financial system. Without reliable redemption, open-ended funds that invest in illiquid assets will always be an accident waiting to happen – however good the disclosure.
Fortunately, market participants don’t have to wait for the regulator to act. A majority of property exposure within DFMs’ model portfolios is now via closed-ended funds, according to FT figures, while open-ended UK property funds have seen sustained outflows for the past 12 months. While regulators ponder the problem, falling demand may ensure that daily-dealing funds holding illiquid assets are soon a thing of the past.
Nick Britton is head of intermediary communications at the Association of Investment Companies
