Business

The investment lie that serves no-one

Governor of the Bank of England, Mark Carney
Governor of the Bank of England, Mark Carney Governor of the Bank of England, Mark Carney

WHO said: “This is a big deal . . . something that could become systemic. These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid”?

It was Mark Carney, governor of the Bank of England, who was referring to illiquid assets (assets you can’t easily sell) held in open ended investment funds (e.g. OEICs and unit trusts).

This was a point made at the end of last week’s column, where we described the performance difference between an open ended and closed ended investment fund. You are likely to be holding both.

Jeff Prestridge, personal finance editor, followed that up in December saying the regulator should ban funds that hold illiquid assets offering daily redemptions (people asking for their money back). There has to be an answer this side of such a drastic action of course.

In the example we showed last week, Picton Property (closed ended) returned 22.5 per cent more than its open-ended version.

Let me explain the risk to you and to the market as a whole:

A key regulatory duty is to manage systemic risk and that risk is pointed out above by Mr Carney.

Open ended funds dominate the UK market. When you as an investor buy into an open-ended fund you are allocated newly created shares. The manager of the fund uses that money to go purchase new assets such as property/shares/bonds etc, so your money can grow.

When you decide you want to encash the investment to go on a holiday/buy a house etc, the manager has to provide that cash, and does so easily using cash they have built up in the fund, or in normal market conditions, there are buyers and sellers, so one funds the other.

The problem occurs when sentiment turns a little sour and the assets they need to sell are illiquid. Illiquid assets include items like property, growth and venture capital, infrastructure and private equity.

Such assets need to be valued, then marketed. The buyer then has to do due diligence, legals and negotiations on some matters can take months, leaving you waiting for your money.

The systemic risk is that these funds are offered with daily liquidity for assets that are anything but that. It is a gross mismatch. Referred to by Mark Carney as being “built on a lie”, the impact on normal investors can be significant.

The manager of a fund moves to protect investors once they receive enough redemptions and so can ringfence/suspend the fund.

The downside of this strategy is that investor’s crowd when they know there is a problem, and herd to exit, often forcing the selling of assets at fire-sale prices.

Closed end funds take advantage of that as we said last week, by borrowing and investing into the assets that are being sold off. The system is broken. Whilst closed ended funds benefit, the market they are in is also being depressed solely by sentiment and herd mentality forcing redemptions through open ended funds.

This serves no-one (other than a shorting - betting on downward price movement investment manager).

Size of this market: Globally over $30 trillion of assets are held in illiquid assets that offer frequent redemptions. The Bank of England believes there to be a liquidity mismatch in more than half of open ended funds.

A downside of this is that OEICs are forced to hold large amounts of cash (average 20 per cent right now) rather than investing, thereby cutting out nearly a fifth of gains that would have normally been achieved.

These problems do not occur in a closed ended fund as they do not offer redemptions, and their shares are what are bought and sold, as opposed to the assets.

German regulations since as far back as 2013 imposed an initial holding period of 24 months for investors in property, as well as a 12 month redemption period.

The investment association is currently working on plans for a hybrid ‘closed/open’ version called a long term asset fund (LTAF), which would be an open ended fund offering access to illiquid assets, but without daily availability.

In the meantime investors should work with a specialised independent financial adviser (IFA) to ensure appropriate liquidity exists across the portfolio.

:: Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have an investment question call Darren McKeever on 028 6863 2692, email info@wwfp.net or visit www.wwfp.net.