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A suitable structure?

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13 June 2019

David Prosser explains why investment companies are more suited to illiquid assets than their open-ended counterparts.

The suspension of Neil Woodford’s £3.7bn Woodford Equity Income Fund is a mess – both for the fund’s investors and for the wider cause of encouraging more people to increase their saving and investment for the future; the headlines now being made by Britain’s best-known fund manager will be a real deterrent to novice investors.

The really frustrating aspect of this affair is that regulators, advisers and investors cannot say they were not warned. This is no one-off shock – these suspensions happen regularly, most recently three years ago when a swathe of property funds had to shut up shop for a period after the EU referendum result sent markets into a spin. Such episodes are an inevitable consequence of holding illiquid assets in an open-ended fund structure.

In a nutshell, if you put hard-to-sell assets in a fund where investors’ withdrawals have to be paid out of the fund, you’re asking for trouble. If there are too many withdrawals, you’ll run out of cash and more liquid assets that you can sell to pay up. Then you’re forced to try to sell the illiquid stuff in a rush, which is a recipe for disaster, or to suspend the fund, which understandably sends investors into a panic. In a closed-ended fund, by contrast, investors buy and sell shares that offer exposure to the underlying assets, but the pool of assets itself is unaffected by these trades.

For those who have spent years sounding the alarm, the difficult thing has been getting anyone to listen. The relative merits of different types of fund structure is a dry, technical debate – people want to know which funds will generate the investment returns they need, not which ones are open- or closed-ended.

The Woodford row is your periodic reminder that this conversation does matter. And if it’s unreasonable to expect all investors to get to grips with it, advisers and regulators certainly have a responsibility to engage on their behalf.

One important lesson here is that investment companies still aren’t getting the support they deserve. For years, regulators maintained an uneven playing field, with open-ended funds allowed to pay commissions to intermediaries, an option that was never available to their closed-ended peers; as a result, advisers shunned investment companies. That anomaly was finally closed down in 2012 with the retail distribution review’s ban on commission payments, but other issues were not tackled – and the legacy of overlooking investment companies remains.

There is no requirement, for example, for advisers offering lists of recommended funds to even consider investment companies; many claim to scan the whole of the market, but ignore closed-ended funds as a matter of course. Open-ended funds, meanwhile, have been allowed to go on offering exposure to illiquid assets, from property to unquoted companies, despite their obvious unsuitability for this task. The rules on risk warnings remain too lax.

Regulators will no doubt consider whether a new approach is required in the wake of the Woodford crisis. But financial advisers should not feel the need to wait for a steer from the watchdogs. Those who have previously written off investment companies as unduly complex for their clients might like to think again about the obvious advantages of a different type of fund structure.

Don’t assume, by the way, that this debate is only relevant when we’re talking about illiquid investments. It’s certainly true that investment companies are a useful way to secure access to asset classes such as private equity, infrastructure, property and many more where liquidity is a potential problem. But even in the most liquid asset classes, including blue-chip UK equities, a manager who does not have to worry about inflows and outflows of investors’ funds has a clear advantage over the competition who does. It leaves them free to get on with the job of managing the fund.

One final point. The other big selling point of an investment company is that it’s a stock market listed entity governed by company law, including the requirement to have an independent board of directors whose duty is to shareholders. Again, this sounds technical. But no such requirement applies to open-ended companies – had Mr Woodford had to answer to such a board at Woodford Equity Income, maybe the current crisis might have been averted.

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