What happens at an investment fund during times of stress?

What happens at an investment fund during times of great stress, such as the rollercoaster ride we have seen on world stock markets in recent weeks? The short answer is that large numbers of investors head for the exit doors – they sell up in a panic.

There’s two important points to make here. Most crucially, it’s vital to remember why you invested in the stock market in the first place – it will normally be because you believed these assets had the greatest potential to deliver better returns over the long term. In which case, you have to accept that short-term ups and downs are the price you pay for this potential – sell up when the going gets rough and you’ll suffer the downside of stock markets while missing out on the upside.

The second point is a little more subtle. It is that the type of fund in which you invest can make a big difference to how you’re affected by a stock market correction.

Forced sellers?

This is because how managers deal with sales of their funds varies according to whether they’re running an open-ended vehicle such as a unit trust or a closed-end fund such as an investment company.

In the former, the open-ended fund manager simply cancels the shares or units of an investor who sells and pays them what they’re owed from the fund’s assets. This is normally straightforward since managers ensure their funds have cash buffers from which they can meet the cost of redemptions; in extreme circumstances, however, when there are a large number of sellers, there may not be enough cash – in which case, the manager has to begin selling investments in order to pay investors.

Inevitably, this is most likely to happen during periods of market crisis. The result is that managers may be forced to cash in investments at exactly the wrong moment – when prices are tumbling.

In a closed-end fund, meanwhile, the structure is different. The fund is of a fixed size and, when investors buy or sell, they do so on the open market. If large numbers of investors want to sell their shares, the price is likely to fall sharply, but the underlying assets won’t be affected – the manager is never forced into asset sales.

But what about the discount?

The flipside of this argument is that the share price of an investment company can get out of sync with the value of the fund’s assets. It may trade at a discount (or a premium) to the value of the underlying assets.

The discount is likely to widen when there are large numbers of sellers of the fund. In which case, investors in the fund are suffering worse losses – at least on paper – than they would if they held the fund’s assets directly, or through an open-ended fund.

That sounds off-putting. But remember two things. First, discounts rise and fall over time, and investment company boards can intervene with measures such as share buybacks in order to bring discounts down. Also, more fundamentally, at least the fund has not had to sell any of its assets – when those assets return to favour, investors will get the full benefit of the recovery. By contrast, investors in an open-ended fund may miss out if their manager was a forced seller.

This is not to argue that closed-end funds are necessarily the best place to be during a market correction. But the structure of an investment company can provide important protection during extreme conditions.