The only way is active?

The Woodford affair continues to cast a dark shadow over the fund management sector, with advisers now scrutinising other open-ended funds, often for the first time, amid concerns they share some of the vulnerabilities that have caused such problems. At the heart of the debate lies an inherent contradiction that open-ended fund managers are struggling to resolve: the liquid, daily dealing they offer in their funds is a mismatch for illiquid assets in the portfolio.

The point is so obvious that many in the market wonder why regulators have never really addressed it. If you promise investors they can have their money back on demand but your fund structure is such that you may need to sell assets to meet those redemptions, you’re heading for problems if the assets in question are hard to sell.

One explanation for regulators’ apparent unwillingness to intervene on this issue may be that while the contradiction theoretically affects every open-ended fund with significant holdings of illiquid assets, there have been relatively few blow-ups in practice. Certainly, the fund-specific problems which led to Woodford Equity Income feeling compelled to shut up shop for a period are pretty rare.

However, in these volatile market times, such complacency looks increasingly dangerous. Three years ago, following the unexpected referendum result, we saw a string of property funds close their doors amid redemption requests they were struggling to meet from portfolios of physical property. The systemic shock of Brexit caused a sector-wider crisis.

Right now, the likelihood of there being similar shocks seems heightened. The continuing threat posed by Brexit uncertainty is just one fear stalking the markets. From the unpredictable trade war between China and the US, to the increasingly difficult outlook for global growth, the list of dangers with the potential to shock in the same way as the referendum result in 2016 is long and growing.

Some fund managers are now taking action independently of any regulatory intervention. Merian, for example, announced last week that it is transferring holdings in several unlisted companies out of its open-ended funds into an investment company it runs instead. The money raised by the open-ended funds will be reinvested in liquid holdings.

Investment companies, of course, do not face the same issues around liquidity as their open-ended counterparts. While investors can get in an out at will by buying the fund’s shares on the open market, the underlying portfolio is a closed-ended fund; redemptions are irrelevant to it.

This is one very significant reason why asset managers launching funds focused on illiquid assets, including property, unlisted securities, infrastructure and more, have so often chosen an investment company structure – even though doing so, at least in the past, limited their capacity to appeal to intermediaries, who have typically preferred the open-ended option.

Regulatory action may, in time, take the issue out of managers’ hands. With both the Bank of England and the Financial Conduct Authority now expressing concern about the dangers of holding illiquid assets in open-ended funds, some form of regulatory action is looming into sight. But even without such an initiative, advisers still recommending such funds for exposure to illiquid assets should be asking themselves some searching questions. When even open-ended fund managers are moving illiquid assets into investment company portfolios, it’s worth taking note.