The Financial Conduct Authority and Bank of England have published their review into how open-ended funds operate, finding divergences in funds’ approaches to liquidity.
The study stemmed from a decision by the Financial Policy Committee (FPC) in 2019 which found a “mismatch between redemption terms and the liquidity of some funds’ assets”.
This means that investors who redeem early find themselves at an advantage compared to others, particularly during stress events, such as the early months of the Covid-19 pandemic.
Last year a raft of open-ended property funds were forced to suspend dealing owing to material uncertainty in the value of underlying properties as the effects of the Covid pandemic hit the market. Most funds have since re-opened apart from the Aegon Property Income fund and Aviva Investors UK Property funds.
The M&G Property Portfolio also remains frozen but has been shut since 4 December 2019 after it received “unusually high and sustained” outflows in the wake of the Brexit vote and shifts in the UK retail sector.
Property funds were also frozen after the Brexit vote in 2016.
The FPC’s original recommendations were that:
- Redeeming investors should receive a price for their units in the fund, which reflects the discount needed to sell the required portion of a fund’s assets in the redemption notice period;
- The liquidity of funds’ assets should be assessed either as the price discount needed for a quick sale of a representative sample – a “vertical slice” – of those assets or the time period needed for a sale to avoid a material price discount; and,
- Redemption notice periods and/or redemption frequency should reflect the time needed to sell the required portion of a fund’s assets.
As a result, the FCA and BoE surveyed a range of UK authorised open-ended funds between August and September 2020 to understand their approach to liquidity and redemption, as well as how to advance the three FPC principles.
The two watchdogs said: “Findings suggest that funds have a large number of liquidity management tools available and, if set out in their prospectuses, their managers utilise them, particularly during stress events.
“Rules allow for discretion on how these tools are deployed. Swing pricing and other anti-dilution mechanisms were widely applied to incorporate the liquidity costs associated with flows faced by funds during normal and stressed market conditions.”
‘Divergencies’
The funds surveyed experienced net outflows in March 2020, which were much larger for funds with predominantly professional investors, and lower for direct retail ones.
While the survey discovered that fund managers demonstrated flexibility in their dilution adjustments and conducted regular liquidity analyses, there were some divergences in the funds’ approaches to liquidity management.
“Tool selection and trigger points for their usage, and some pricing adjustment calculations, were set across a fund manager’s different fund ranges, with lesser regard to the specific investment strategy of the funds and/or the type of assets they held,” the FCA and BoE said.
“There were significant differences in how similar funds facing similar flows applied swing pricing. Some fund managers used discretion to switch from partial to full swing pricing. Fund managers reported mainly using bid-ask spreads, followed by explicit costs of the transaction – eg commissions and fees – as the main components in calculating swing factors.
“Most funds managers did not factor market impact explicitly into their swing factors. Few had models in place to estimate fixed-income spreads when needed. Some of the differences in swing factors might be explained by fund-specific characteristics, such as the fund’s primary strategy or the liquidity of the underlying assets, or whether the fund experienced net flows.
“But there were variations that could not be fully explained by these factors.”
Consequently, the two watchdogs have proposed that open-ended funds will need to:
- Ensure the time it takes investors to redeem their money matches the fund’s ability to sell its assets to meet redemptions;
- Classify their assets according to how easy they are to sell; and,
- Adjust prices to reflect market conditions.
The FCA and BoE added: “This will ensure that there is more consistency between the ease with which investors can access their money and the ease with which a fund can sell its assets. Such consistency will support financial stability and give greater certainty to investors.”
II thinks fund managers are ‘overly optimistic’ about liquidity
Interactive investor head of personal finance Moira O’Neill said: “Liquidity issues around open–ended funds have tended to focus on property, and today too many property fund investors still have their savings sat on ice – a disgrace.
“But today’s research hints at a broader open–ended issue that has until now been hidden under the carpet – namely, that fund managers are often overly optimistic about how quickly they can sell their holdings.
“This is something we have been concerned about for some time. In November, we encouraged the FCA to consider whether current disclosure requirements around illiquid assets go far enough.
“We also said that the FCA should also consider whether redemption periods should be applied to funds investing in illiquid equities (not just property). And with many fund managers apparently overestimating their liquidity, according to today’s research, the regulator has some careful thinking to do.”
AIC says it shows dangers of illiquid assets in open-ended structures
AIC chief executive Ian Sayers said the findings are an important warning of the dangers of open–ended funds investing in illiquid assets.
“This is timely as policymakers are currently considering greater use of open–ended funds to hold less liquid assets, for example through the proposed Long-Term Asset Fund (LTAF),” he said.
“The conclusion that fund managers appeared to be too optimistic about how quickly they can sell holdings is particularly worrying. Without effective regulation to ensure more realistic assessments of liquidity, there is a risk that liquidity mismatches in open–ended funds will increasingly present a threat to financial stability.”
He added: “The FPC highlights that for funds investing in highly illiquid assets swing pricing may not work effectively and longer notice periods are a better alternative. This accords with the AIC’s view that longer notice periods are crucial to address the risk posed by the liquidity mismatch in open–ended funds.”
