Ian Sayers, Chief Executive of the AIC, argues that ‘reliable redemption’ is the only way to address the fundamental problems of holding illiquid assets in open-ended funds and to prevent systemic risks.
With the announcement that Woodford Equity Income Fund will be liquidated, I am sure everyone hopes that investors will get as much of their money back as soon as practicable. However, investors might also expect that measures were in hand to prevent these types of problem from happening again. Unfortunately, they are not.
The FCA’s recent paper on open-ended funds holding illiquid assets is a case in point. The regulator has made changes that appear to be a move in the right direction but fall far short of what is required and only apply to some funds. For example, the new rules only apply to funds with more than 50% in illiquid assets, well above the level of unlisted shares that Woodford Equity Income Fund held. The rules will also not come into force until September 2020 despite it being three years since the suspension of open-ended property funds after the Brexit referendum.
Above all else, what these rules fail to do is to provide retail investors with reliable redemption. Retail investors should not buy into a fund offering daily redemption on one set of conditions, only to find that, further down the line, these conditions change or, worse still, that they cannot get out at all.
Disclosing in the prospectus that the conditions on which you can leave a fund might change, or that the fund may be suspended, is not adequate or fair. When I buy a car, I expect the headlights to work under all reasonable driving conditions. I should not have to wade through the manual to find a warning that they might not work in the wet. As IOSCO (the international body of securities regulators) has confirmed repeatedly, suspension is a measure of last resort that should only be required in unforeseeable circumstances. The FCA’s rules do not meet these standards.
Reliable redemption would have to observe two key principles:
- The basis on which an investor could leave the fund would not change, irrespective of the level of redemptions. Suspensions would only occur, as IOSCO recommends, if the fund faced unforeseeable difficulties.
- To ensure this, the redemption terms would be fixed at the outset by reference to the length of time it would take the manager to sell sufficient assets in an orderly market to meet the maximum level of foreseeable redemptions whilst maintaining the balance of the portfolio.
Funds with liquid portfolios could still offer daily redemption of an investor’s entire holding. At the other end of the spectrum, for a fund invested in the most illiquid assets, the ability to redeem the entire holding might have to be subject to, say, a year’s notice.
This may not be attractive to some investors, of course, and funds with more restrictive redemption terms might not be appropriate for retail investors. But illiquid assets are inherently long-term investments and the redemption terms would simply reflect the reality of selling the underlying portfolio. Surely it is better and fairer to limit redemption upfront, so investors can plan accordingly, rather than to lead them to believe they have rights to daily redemption which evaporate when market conditions deteriorate?
Reliable redemption would have many benefits:
- It would prevent the sale of assets at distressed prices. Though the initial suspension of Woodford Equity Income Fund prevented an all-out fire sale, we still saw reports of investments being sold at prices less than might otherwise have been achieved.
- It would prevent ‘first mover advantage’. Given the experience of Woodford Equity Income Fund, investors are likely to be keeping a closer eye on other funds that might go the same way. Inevitably, more sophisticated professional investors, who can better understand the changing liquidity profile of the underlying portfolio and monitor redemption patterns, can be expected to move first if they think there is a chance the fund might be suspended.
- It would protect the balance of the portfolio. One of the problems with offering redemption within a short timescale is that it is often the most liquid assets that are sold first. If redemptions are substantial and sustained, the portfolio can change radically in terms of its remaining liquidity, prejudicing remaining investors.
- It would mean that retail investors would not be at the mercy of institutional investors when it comes to whether they can exit a fund or not. Had Kent County Council pension fund not asked for its entire £250m investment back from Woodford Equity Income Fund, then Mr and Mrs Smith with their £10,000 investment could possibly still have left the fund.
- It would eliminate the need for large cash buffers. The FCA believes that the new rules should address this, but I doubt this is correct. If property funds can still offer daily redemption under the new rules, as appears to be the case, then managers (as they are doing now) will continue to hold substantial cash buffers which are a drag on performance and means investors are paying fees for their money not to be invested.
- It will help to address the systemic risks that Mark Carney has identified if funds were subject to something akin to a run on the banks. These risks extend beyond simple consumer confidence to questions of financial stability, yet it barely gets a mention in the FCA’s paper.
The FCA has promised a further review, but it is far from clear whether they will address these issues. I was very concerned to read that the FCA does not consider that how often funds suspend is a measure of success or failure. I doubt many investors in Woodford Equity Income Fund would agree. This ‘normalisation’ of suspension is perhaps the most worrying trend in recent months and perhaps reflects the fact that, under the FCA’s new rules, suspensions are likely to become more frequent, not less.
Until this positive view of suspension changes, I do not think any reform will address the root cause of the problems.
Ian Sayers is Chief Executive of the AIC
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