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A liquidity mismatch?

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12 July 2019

David Prosser discusses the recent FPC Financial Stability Report, pointing towards open-ended vs closed-ended funds for holding illiquid assets.

The Bank of England’s Financial Policy Committee isn’t in the business of offering financial advice – its remit is to head off systemic risks to financial stability. Still, the FPC’s latest Financial Stability Report, published in recent days, drops some pretty heavy hints about policymakers’ views on the use of open-ended versus closed-ended funds for holding illiquid assets.

Published in the aftermath of the suspension of Woodford Equity Income, imposed after redemption requests threatened to turn it into a forced seller of illiquid unlisted stocks, the report discusses whether such crises could cause financial stress. The FPC’s conclusion is that regulators such as the Financial Conduct Authority, currently reviewing reforms around open-ended fund investing in illiquid, are right to be concerned. And leaving aside the systemic risks posed by this issue, the FCA also highlights some of the fundamental arguments for using closed-ended funds for exposure to illiquid assets such as unquoted stocks, commercial property and other asset classes where trading is not straightforward.

This is important. The thing about crises such as the Woodford debacle is that they feel like isolated flare-ups. The big danger of holding illiquid assets through open-ended funds lies not so much in the possibility of a Woodford-style suspension; these are a genuine risk but are fortunately rare. Rather, it’s the potential for less obvious detriment on an ongoing basis.

For example, open-ended funds with illiquid assets are duty-bound to hold a chunk of the portfolio in cash, so as to be confident of being able to meet run-of-the-mill redemption requests that happen all the time. Money held in cash can’t be invested in the assets to which the fund purports to offer exposure – investors are paying for something they’re not getting in full and will miss out on performance when these assets are rising in value.

Another difficulty is that the open-ended structure sets different groups of investors against one another. Sellers have to be paid, which may require the fund to dispose of assets that ongoing investors would prefer to be retained. Sometimes, moreover, the fund manager will end up selling more liquid assets in the portfolio, because doing so is easier, even if this has an unfavourable impact on returns.

A related issue is that the structure of open-ended funds may compel investors to make decisions they’d rather not. The problems caused by sellers create an incentive for other investors to sell too; they naturally feel the need to get out of the fund before forced asset disposals develop into full-blown fire sales. Other things being equal, they might have preferred to stay put.

Such difficulties effectively mean that managers of open-ended funds with illiquid portfolios are operating with one arm tied behind their backs. Even without the sort of blow-up seen at Woodford Equity Income, or at commercial property funds in the wake of the Brexit referendum, investors’ interests are at risk.

All of which brings us back to closed-ended funds. Their structure insulates investors from the liquidity issue. Whatever happens in the underlying portfolio, investors can buy and sell the fund’s shares freely on a public exchange. With no redemptions to worry about, closed-ended fund managers never have to be forced sellers. Investors’ interests are protected, with no single group disadvantaged compared to another.

This is not to say closed-ended funds invested in illiquid assets carry no risk. In difficult periods, the discount at which their shares trade relative to the value of the underlying portfolio may widen considerably. Crucially, however, the portfolio stands apart, with no compromise of recovery prospects for those investors who stick with the fund.

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