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Liquidity lessons

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20 November 2020

David Prosser discusses and argues against perceived investment company liquidity issues.

Investment companies have had a good crisis, it is generally accepted, bouncing back strongly from the stock market volatility of the Spring and providing succour for income-seeking investors as dividends crashed amid the Covid-19 crisis. A leading adviser’s comments in recent days that the sector is potentially facing an existential crisis have therefore raised some eyebrows.

The adviser in question pointed to consolidation in the wealth management and financial advice market, which is concentrating power in the hands of a small number of increasingly large players – including the big online platforms, whose lists of best buy funds are now so influential. The argument is that these platforms will find it ever more difficult to recommend investment companies because most funds lack the liquidity necessary to deal with the weight of money that moves in their direction on the basis of this advice.

There is some logic in this idea. When demand for an open-ended fund spikes upwards, its managers have only to issue more units to mop up this cash. In a closed-ended investment company, this isn’t an option; investors must buy their shares on the secondary market. Where supply is insufficient, the price of the investment company’s shares will rise accordingly, undermining the validity of the recommendation. Investors may end up buying the stock at a substantial premium to the value of the underlying assets.

This is the thinking behind the consistent refusal of Hargreaves Lansdown, one of the biggest platforms, to include investment companies in its Wealth 50 list of recommended funds. The closed-ended funds it likes would not be able to service the kind of demand that Wealth 50 generates, the platform argues.

Hence the existential threat. If we end up with a wealth management market where a few platforms dominate – and others take the same view as Hargreaves Lansdown – will investment companies struggle to survive?

In fact, there are several arguments that need unpicking here. First, investment companies themselves hotly dispute the idea that their liquidity is a bar to inclusion on best buy lists. The largest funds in the industry – including the likes of top performing Scottish Mortgage – are highly liquid, with daily dealings that run into millions or even tens of millions of pounds; several are members of the FTSE 250 Index (Scottish Mortgage is a FTSE 100 constituent). Indeed, several of Hargreaves Lansdown’s biggest rivals do include investment companies on their flagship best buy lists and do not appear to have had problems.

Just as importantly, to think of investment companies as only operating in the same marketplace as the large mainstream open-ended funds is to hugely underestimate the breadth of the industry. There certainly are plenty of investment companies that offer a broad and generalist value proposition; but there are many more that offer specialist exposure to particular areas of the market or to alternative asset classes. These funds will continue to be popular with advisers and investors alike; in many cases, they represent the only means of accessing the assets to which they offer exposure.

It is also vital to recognise that while the structure of investment companies may pose certain challenges, it also has clear advantages. It offers a better governance model, provides access to illiquid assets, and gives the income-smoothing benefits that have been so badly needed this year. These are reasons to think the investment company industry will flourish rather than falter.

One final point. Investment companies have a long and proud history of innovation, including a strong record of responding to problems that might otherwise cause them to fall from favour. In the event of liquidity issues becoming one of those problems, you can expect more of the same; indeed, we are already seeing some of the larger funds experiment with share issuance programmes.

For all these reasons, talk of existential threats to the industry looks wide of the mark. In fact, one legacy of the Covid-19 crisis is going to be much wider recognition of what the investment companies industry has to offer. That will only increase the number of advisers and investors taking an interest in the sector (and improving liquidity along the way).