How attractive is the FCA’s proposed solution to the 'liquidity mismatch' issue that plagues open-ended funds?
by Andy Davis
Open-ended investment funds have a long pedigree. The first unit trust was launched by M&G in 1931, seven years after modern-day mutual funds appeared in the US. In 1997, an updated version, the open-ended investment company, came into being in the UK and since then these vehicles have mushroomed. UK open-ended funds doubled assets under management (AUM) in the decade to 2010 and did even better in the following ten years, reaching £1.3tn by the end of 2019, according to figures from The Investment Association (IA).
By that point, a little over £28bn was held in open-ended property funds – 2% of total AUM in round numbers. But what a fuss that paltry 2% has caused.
Several times since the 2008–2009 financial crisis, open-ended property funds have had to block investors from withdrawing their money. This is normally because, in times of market panic, the managers cannot even get reliable valuations for their buildings, let alone sell them fast enough to pay everyone trying to exit. Some open-ended property funds remain suspended following the market crash in March 2020, after their valuers determined the impact of the pandemic had created 'material uncertainty' over the valuation of UK property. However, as of 16 September 2020, the UK's largest property fund, L&G UK Property, will reopen on 13 October. The board reports there are no new material issues that have come to light.
The FCA has at last put forward proposals to address the basic problem with these funds, namely that they hold assets – buildings – which are impossible to buy and sell in a hurry, within an unlisted fund that promises investors 'daily dealing'. The FCA is proposing that, to get around this problem, daily dealing should end and we should give up to six months' notice if we want to sell some or all of our stake. This would allow managers to raise the money in an orderly fashion. That's right. Six months.
"These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren't liquid”
No less an authority than Mark Carney, former governor of the Bank of England, observed before a select committee of MPs that "these funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren't liquid". A lie that takes six months to put right is a pretty big lie.
Investing in open-ended funds make sense when the assets they hold are reasonably easy to buy and sell: large- and mid-cap equities, government bonds, decent quality corporate bonds and so on. Investing in property also makes sense – it can offer a reasonable source of income, capital growth and a partial hedge against inflation. Putting the two together, on the other hand, makes much less sense.
The fact that the obvious problem with holding large, illiquid assets in an open-ended fund structure did not stop asset managers from attempting it is probably down to the single biggest attraction of this type of fund. Thanks to their straightforward pricing, they are much easier for private investors to understand than the obvious alternative – closed-end funds – and, therefore, much easier to sell.
Their closed-end counterparts, stock market-listed investment trusts, have a longer pedigree, dating back to 1868 when Foreign & Colonial Investment Trust was launched. But they are fiddly and complicated by comparison with open-ended funds and consequently tend to baffle many retail investors. Unfortunately, the very things that make them baffling also mean they are perfectly suited to holding illiquid assets such as property.
Their closed-end counterparts, stock market-listed investment trusts, have a longer pedigree, dating back to 1868Investment trusts are companies whose shares are listed on the stock exchange, enabling them to offer daily dealing as open-ended funds do. There the similarity ends.
The reason most people cannot fathom investment trusts is that they have a share price and a net asset value: the per-share value of the assets the trust owns. These two prices usually differ, so the share price can trade at a discount to the net asset value or at a premium. If someone wants to sell shares in a property investment trust, the stock market will provide a buyer – the fund manager never has to sell a building so that an investor can exit.
This is what makes investment trusts fiddly to explain (see, I just tried). But it also means that these funds have a built-in mechanism to cater to people who want to invest in illiquid assets and to be able to sell out at will.
In panics, investment trust shares will tend to fall to a big discount to the trust's net asset value. Investors can sell, but they must accept less money for their stake than the underlying assets are worth. That's the price of getting out in a hurry when markets are tumbling.
The genius of this structure is that it lets market forces decide how big a penalty we must pay to get our money back quickly. The penalty can change by the hour as the market's view of the situation evolves – better that than a fixed, six-month wait.
The FCA has come up with an entirely logical answer to the so-called 'liquidity mismatches' that plague open-ended property funds. But for all its logic, the proposed solution is so unattractive that it serves only to highlight the real problem here. Open-ended funds are not the right vehicles to hold illiquid assets. Investment trusts are.
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