Illiquid assets in open and closed funds

Illiquid assets in open and closed funds – Avoid fund fractures with regular stress tests

Hannah Smith, Money Observer, December 2019

Investors trapped in the beleaguered Woodford Equity Income fund were hoping that the shuttered fund might reopen in December and they could get their money back. But instead of a Christmas miracle, they’re getting a lump of coal in their stocking, with heavy losses likely as the fund is wound up.

This case has shocked the fund management industry, and raises the question of whether funds should face bank-style stress tests to make sure they can meet redemption requests in falling markets.

..But there isn’t a formalised, standardised process across the industry for voluntary stress-testing of funds. Bank of England governor Mark Carney wants to apply industry-wide stress tests because he says more than half of funds have a ‘structural mismatch’ between the frequency with which they offer redemptions and the time it would take them to sell assets. The Bank fears this could result in firesales and amplify market swings.

Investment trusts have the edge

…Some commentators have suggested that stress-testing is not the answer, and that in fact illiquid assets are better held in closed-ended vehicles whose structures are more suited to this type of investing.

James Carthew, head of investment company research at Marten & Co, argues that open-ended funds should be banned from holding illiquid asset altogether.

‘We’ve been fairly strident in saying we don’t think you should hold any illiquid assets in open-ended funds’ he says. ‘That definitely goes for the property funds. They just shouldn’t exist. If {asset management groups} just convert them all into real estate investment trusts, the problem goes away and investors are much better protected. We don’t understand why the FCA won’t make that move.’

Carthew flags up the possibility that small-cap and micro-cap open-ended funds could be the next ones at risk of liquidity problems if sentiment suddenly shifts. ‘If you’ve got a fund that’s holding a lot of very small companies and then you suddenly get a big redemption, it’s quite hard to turn that into cash.

‘If you want to invest in those sorts of things, it’s a much better idea to go for the investment trust structure,’ he says.