Are illiquid funds built on a lie?

The liquidity of investment funds has come into sharp focus in recent weeks, following the trading suspension imposed on investors in the Woodford Equity Income fund.

The fund, which had a large percentage of its assets invested in illiquid stocks, has been the cause of much debate.

The Bank of England governor, Mark Carney, has now thrown his weight behind criticism of the fund, explaining that such funds are “built on a lie.”

His comments refer to the inclusion of illiquid assets in funds which supposedly allow investors instant access to their money.

It’s not the first time easy to trade open-ended investment funds holding hard to trade assets have come under fire.

In the wake of the 2016 Brexit referendum, some open-ended property investment funds had to place trading restrictions on investors, as they were unable to sell assets fast enough to meet redemption requests.

Carney told MPs that “these funds are built on a lie, which is you can have daily liquidity.” Where investment fund assets “fundamentally aren’t liquid”, said Carney, or could become illiquid during a market downturn, that “lie” could lead to market instability, as it results in investors expecting the same kind of access to their money as they might expect from a bank account.

Carney explained to MPs that investors should expect terms in line with the liquidity of the assets, and therefore not assume instant access should they wish to sell their holdings. He said: “We do have to be very deliberate about the types of measures that need to be taken — something that better aligns the redemption terms with the actual liquidity of the underlying investment is infinitely preferable to the situation we have today.”

While his comments were not aimed explicitly at Neil Woodford, they came only a day after Financial Conduct Authority chief executive Andrew Bailey alleged the Woodford fund had exploited regulations “to the full” and had been “sailing close to the wind” when it came to its holdings in illiquid assets.

European rules for investments, known as Ucits, say that investment funds with daily dealing must hold no more than 10% of assets in illiquid assets, such as unquoted stocks.

The FCA chief revealed this week that only two UK investment funds, out of a total of around 3,000, had breached these Ucits rules on illiquid assets. One fund to breach the limit was Neil Woodford’s Equity Income fund, with the other an unnamed small fund.

In response to the suspension of commercial property funds after the EU referendum three years ago and the recent Woodford situation, the Investment Association (IA) is working on proposals for a new type of ‘long-term asset’ fund that could hold illiquid assets. These partially open funds would restrict investor withdrawals to certain 'windows' in the year. They would in all likelihood be unavailable to DIY investors and would only be made available to investors receiving financial advice or who had passed ‘appropriateness tests’. The IA aims to publish a ‘detailed blueprint’ for long-term asset funds later this year.

So what does this all mean for investors? The first thing is that when selecting suitable investments, matching the liquidity of underlying assets with your requirements to access your money is an important consideration. Remember, investing is for the long-term. If you may need to access your money in the next five years, factor that into your savings and investment choices.

Secondly, if you do decide to invest in illiquid or hard to trade assets, then a closed-ended fund structure, typically an investment trust, could be better suited than the open-ended funds which have a liquidity mismatch.

Thirdly, don’t forget the need for diversification. It is important to spread your money across bonds, equities, property, fund managers, countries and sectors.

Also, don’t automatically buy into the hype surrounding 'star' fund managers. Remember that past performance is not necessarily a guide to future performance. 

And finally, do consider getting financial advice. If you would like to discuss your financial affairs and investment plans in the light of recent events, feel free to contact Kellands.

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