Liquidity mismatch: the new rules

17 August 2020

By Ken Rayner, Verbatim RMSR Model Portfolio Manager

Investment trusts aren’t always a popular choice with advisers and back in January we talked about the potential issues and negativity around this type of investment. The topic is now back in the spotlight as the Financial Conduct Authority (FCA) is consulting on new rules to improve open-ended property fund structures which would reduce the potential for harm to investors from the liquidity mismatch in open-ended property funds. The new rules would require investors to give providers between 90 and 180 days of notice before their investment can be redeemed.

Investment trusts have been around for some time, we currently rate the first ever trust, the Foreign and Colonial Investment Trust, which was set up in 1868. Closed investment trusts are traded on the secondary market so there is more than one price point. They trade between 08:00 and 16:30, are subject to market sentiment and can trade at a premium or a discount to net asset value. Flows don’t have to be managed so illiquid assets are less of an issue.

We rate mainly open-ended investments in the form of unit trusts or open-ended investment companies (OEICs). Both are professionally managed, collective investment vehicles where a fund manager pools money from many investors and buys shares, bonds, property, cash assets and other investments.

With an open-ended fund, investors can buy and sell units on a frequent, often daily basis, but the underlying assets may not be able to be bought and sold at the same frequency, which can create a liquidity mismatch. Illiquid instruments held in open-ended products can cause an issue when too many investors simultaneously wish to redeem their investments. A fund manager may need to suspend dealings in the units of the fund if they can’t sell enough of their underlying portfolio to meet redemptions or if they don’t have enough cash. Fund suspensions have occurred with increasing frequency in recent years, particularly since Brexit and more recently as a result of the current coronavirus pandemic.

Fund suspensions are there to protect investors in exceptional circumstances but the frequency of suspensions in recent years suggests that there are wider problems. The liquidity mismatch has been in sharp focus since the well-publicised issues surrounding Woodford Investment Management and property funds are where this problem most often rears its head. There is currently over £12.5 billion of investors’ savings trapped in suspended open-ended property funds.

The concern with the structure as it stands is that it incentivises investors to be the first to exit at times of market stress and this can damage those who stay in the fund if it is suspended, or if assets have to be sold rapidly due to liquidity demands.

The proposed notice period of up to 180 days would allow the manager to plan sales of property assets to better meet redemptions and it would mean greater efficiency within these products as fund managers would be able to allocate more of the fund to property and less to cash for  unanticipated redemptions.

Christopher Woolard, Interim Chief Executive of the FCA, says ‘We want open-ended funds to provide a structure through which investors can safely invest in less liquid assets which offer

attractive expected returns and at the same time supports investment that benefits the wider economy. We hope the proposed new rules will directly address the liquidity mismatch of these funds making them more resilient during periods of stress, allowing them to operate in a way that all investors are treated equally.’

The consultation will stay open until 3rd November 2020 and the rules will be finalised and published by the FCA in 2021. Notice periods won’t stop all property fund suspensions, in times of severe market stress property managers may still not be able to sell properties quickly enough, but managers will have greater flexibility to meet redemption requests and investor’s perceptions of what to expect should change.

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. The contents of this article should not be construed as advice and is for information only. Individual stock selection should only be performed by suitably qualified advisers.