Liquidity learnings

David Prosser explains why liquidity may not be as big a problem as people think for investment companies.

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Many of the UK’s largest wealth managers and investment platforms worry about becoming the dog who chases its own tail when it comes to investment companies. Their services very often depend on a small number of model portfolios, which means they manage large sums under each strategy; the danger when trying to move client money into an investment company is that they keep shifting its share price higher.

This liquidity issue is often cited by wealth managers and platforms as a reason for steering clear of investment companies – yet another leading firm said exactly that this week. The model portfolio approach, they argue, means that even the largest investment companies may struggle to cope with the demand they can generate. This is also why you are less likely to find investment companies on many firms’ lists of recommended funds.

Hmm. It is true that the structure of an investment company, a closed-ended fund, means a spike in demand may lead to a rising price, irrespective of what is going on with the underlying assets; and there are a good chunk of smaller funds where this is a particular risk. Equally, however, there is no shortage of larger investment companies – getting on for half of all closed-ended funds are capitalised at more than £400m and a sizeable minority are much larger. Even the largest wealth managers and platforms should be able to find funds offering sufficient liquidity; a carte blanche refusal to use investment companies is therefore misplaced.

However, there is a more fundamental issue here. If you are an intermediary offering clients an investment service that you feel has no choice but to avoid vehicles that offer the potential for both superior performance and improved diversification, maybe you should rethink the way you offer that service.

There is not much serious debate about either of those advantages of investment companies. On performance, studies have repeatedly shown that, on average, investment companies tend to outperform their open-ended peers over longer term periods. Drivers of that outperformance include investment companies’ ability to take on gearing and their record of lower charging, and the numbers are undeniable.

Equally, investment companies offer access to a broader range of assets offering important diversification benefits. Asset classes such as infrastructure, real estate and private equity are either unavailable via open-ended funds, or problematic given the mismatch between the illiquid nature of these investments and the structure of open-ended funds.

For these reasons, any intermediary that rules out placing clients’ money in an investment company is doing them a disservice. They are effectively telling clients that they will be deliberately avoiding investment vehicles with a record of providing a more attractive risk and return profile. That seems like a very peculiar thing to do.

Model portfolios are, of course, a compromise. They try to create one-size-fits-all investment solutions for clients who have broadly similar needs and attitudes to risk, but whose individual circumstances differ. In that sense, maybe a blanket avoidance of investment companies is just another part of the bargain investors have to accept when signing up for this sort of service.

Still, it is a dispiriting situation – and there is a good chance many investors are not aware of what is happening. Intermediaries that purport to offer clients the best investments from across the whole market ought to try harder to do exactly that.