A safer structure

Christopher Woolard, interim chief executive of the Financial Conduct Authority, isn’t having the easiest summer. Last month’s announcement that the London Stock Exchange’s Nikhil Rathi will take the top job at the FCA in the autumn – not Mr Woolard himself – surprised many in the City. And while he waits for his new boss to arrive, Mr Woolard has the poisoned chalice of property fund reforms to oversee. In recent days, he has promised to consult on new structures to mitigate the problems that have dogged open-ended property funds time and again in recent years.

Best of luck with that. The problem is that in an open-ended vehicle, there is no structure capable of reconciling the fundamental mismatch between the promise to investors that they can access their cash whenever they like and the reality that property is an illiquid investment. Every time large numbers of investors take fund managers up on the promise, open-ended funds crash back into this mismatch; managers simply cannot realise property investments quickly enough to pay up.

Even worse, managers’ efforts to keep their promise are highly damaging to investors wanting to stay put. Managers are forced to sell assets when they do not wish to do so – often at the most inopportune moments – and at prices they would not otherwise accept.

We know what happens in this situation. Every time that a crisis in market confidence has prompted panicked investors to dash for cash – from the financial crisis to Brexit to the Covid-19 pandemic this year – there has been a run on open-ended property funds. Each time, managers have been forced to suspend withdrawals, locking all investors into the fund until the crisis passes.

Managers can’t be blamed for gating funds in this way. It has been the only way to protect the interests of investors – particularly those holding on for the long term, who are otherwise exposed to losses crystallised in the rush to keep departing investors happy. The fault lies with the structure of an open-ended fund itself.

What is the solution? Well, first, the FCA is going to have to stop pretending that there is some clever technical solution or convoluted workaround that can render this asymmetrical liquidity irrelevant. There just isn’t. Second, financial advisers need to stop recommending open-ended funds to investors looking for exposure to property.

There is, after all, a perfectly credible alternative. The closed-ended structure of an investment company provides a straightforward means to invest in illiquid assets such as property while maintaining daily liquidity. Investors who want out of such funds simply sell their shares on the open market to whoever is prepared to buy them; there is no effect on underlying portfolio.

Investment companies don’t offer a panacea in tough market conditions. During each crisis, shares in closed-ended property funds have fallen sharply – often more sharply than the value of the portfolio itself. Crucially, however, the long-term interests of investors are protected because there is no need for a fire sale of assets to cover the cost of redemptions. And those investors who do want to sell always have a means of doing so.

It’s so simple that it’s difficult to understand why the penny has yet to drop for so many – including the regulator. There is plenty of room for argument in the debate about the relative merits of open-ended funds and investment companies, but when it comes to illiquid assets there’s no doubt at all about which offers the better way forward.