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Liquidity: a common anxiety, a common misconception

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12 June 2015

David Prosser takes a look at how much of an issue liquidity really is in the investment company sector.

One common anxiety for independent financial advisers considering the investment company sector is that they’ll find it difficult to buy and sell the funds they want. They worry that the closed-end fund market lacks liquidity – larger advisers in particular, which may be making very sizeable aggregate trades on behalf of many clients, sometimes point to this issue as a reason not to invest.

To some extent, this is a chicken-and-egg issue. The more advisers who deal in investment company shares, the better liquidity will be – equally, the more that steer clear, the more this will be a problem for those who do want to invest.

But how big a problem is liquidity in the investment company sector right now? In fact, the latest analysis from Winterflood Investment Trusts suggests advisers may be getting concerned for no reason – particularly at the larger end of the sector.

At the end of May, Winterflood points, there were no fewer than 216 investment companies with a market capitalisation greater than £100m, the size at which the analyst says wealth management companies typically regard a fund as being large enough to provide sufficient liquidity for their needs. Clearly, then, there is no shortage of choice.

With that size, moreover, comes other advantages that advisers may appreciate. It is noticeable, for example, that the shares of larger investment companies tend to trade at narrower discounts to the value of their underlying assets.

Similarly, bid/offer spreads tend to be narrower at the larger funds. Over the past 12 months, the typical bid/offer spread on a fund in the top quarter of the sector by market capitalisation, has been 0.3 per cent, Winterflood’s analysis shows. That figure has fallen since August 2013, the last time Winterflood took the sector’s temperature in this way – a sure sign that liquidity has been improving.

Other evidence points to that too. The larger funds have recorded significant increases in average daily trading volumes since August 2013. More than 40 investment companies have seen daily transactions in their shares average more than £1m over the past year.

Does that mean financial advisers who fret about liquidity have got it all wrong? Well, not necessarily – Elliott also concedes that “there is always likely to be a tail of funds in which secondary market liquidity is poor”.  Indeed, bid/offer spreads amongst the smallest investment companies have widened over the past year, while the bottom quarter of funds by size have seen average daily transaction volumes fall.

However, this is no different to any other sector of the stock market. All exchanges have larger companies where liquidity is stronger and smaller companies where it may be more of an issue. For those investors for whom liquidity is a consideration, the sensible response is to avoid the tiddlers – not to steer clear of the market altogether.

Broadly speaking, though, financial advisers can invest in closed-end funds safe in the knowledge that they’ll be able to place the trades they need. “Our analysis suggests that the majority of investment trusts offer reasonable liquidity,” concludes Winterflood’s Simon Elliott. “Indeed, at the larger end, we would argue that liquidity is good and showing signs of improvement.”

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