The UK’s most famous fund manager has been having a terrible time recently – or perhaps infamous is a better way to describe Neil Woodford these days.
Trading in Woodford’s £3.7bn Equity Income fund was suspended last week after a stampede of investors rushed to get their money back. Those remaining are now stuck, and have been advised to brace themselves for a suspension longer than 28 days.
Despite the anger and frustration, Woodford has refused to waive the management fee, which many (including Financial Conduct Authority chief Andrew Bailey) have argued would have been an appropriate gesture of goodwill towards savers.
Unsurprisingly, investors – many of whom have used Woodford’s fund for their Isa or pension – are concerned, with some questioning why they were not sufficiently warned that their money could be locked in.
In reality, a suspension can happen to any open-ended fund, but the risk is greater when managers are invested in hard-to-sell illiquid holdings, such as property or unlisted stocks.
With open-ended funds (otherwise known as mutual funds), there are no limits to how many shares can be issued. This means that when investors buy shares in the fund, more shares are created. While this isn’t a problem when people are buying, if lots of investors decide to sell their shares at once, the fund manager might be forced to sell assets at discounted prices in order to quickly raise the cash to pay them.
Essentially, the fund manager has to manage the portfolio to accommodate inflows and outflows, ensuring that they have enough money available to give investors back their money, says Annabel Brodie-Smith from the Association of Investment Companies. “When the chips are down, the fund manager cannot sell the illiquid assets quickly enough to meet investor redemptions, despite retaining a cash cushion for these situations.”
The other issue is that fund-gating – that is, temporarily preventing people from withdrawing their money – inevitably brings bad publicity to the open-ended fund, therefore creating a sort of negative feedback loop, potentially prompting a further run on a fund once the suspension is lifted.
Where Woodford is concerned, his problems really arose when he ramped up his allocation to unquoted stocks to exceed the regulator’s 10 per cent limit in his flagship fund. What’s worse is that some of the positions in these unlisted stocks were quite large, making them all the more difficult to sell.
Perhaps if Woodford had stuck to the rules and not gone beyond the unquoted threshold, the fund wouldn’t have been forced to suspend. But really there is a bigger issue at play here, because this scandal has drawn attention to the risks when the underlying investments don’t align with the intended flexibility that the structure of the product is meant to provide.
“Open-ended funds which hold illiquid assets have a fundamental mismatch, as their daily dealing structure simply doesn’t match the reality of trading the underlying investments,” says Edward Park, deputy chief investment officer at Brooks Macdonald. “For this reason, within the property fund sector we now exclusively buy closed-ended listed investment vehicles.”
Issues around this really came to light in the months after the Brexit vote in 2016, when a string of large property funds were forced to suspend trading after thousands of investors panicked and cashed in.
It’s a mechanism that is designed to protect the remaining investors, giving managers time to sell off the underlying investments. But it’s also a predicament that could be avoided simply by preventing illiquid investments from being held in open-ended funds.
This is something that the Financial Conduct Authority is currently looking into, and Bailey has warned that daily withdrawals from funds holding illiquid assets could be banned.
The regulator is due to publish a policy statement containing final rules by the end of this month.
That’s not to say that illiquid investments are bad, it’s just that other structures are better suited to holding these types of assets.
For example, listed investment companies (commonly known as investment trusts) with a closed-ended structure are more suitable for investing in assets like unquoted shares, because managers don’t have to worry about money coming in or leaving the fund. Investment companies only have a set amount of shares available, which can be bought on an exchange like individual stocks.
The share price is affected by supply and demand, meaning it can trade at a premium or discount to its net asset value, without directly impacting the underlying businesses that the investment trust is invested in.
“While negative news might prompt a fall in the investment company’s share price, the portfolio will be unaffected,” says Brodie-Smith. “Investors may not like the investment company’s share price, but they can continue to buy and sell the investment company if they wish to.”
So essentially, for investors who want the assurance of daily liquidity, investment companies may be a better idea.
As Marc Haynes from Cohen & Steers says: “Investors can no longer afford to turn a blind eye to the structural flaw of open-ended funds – the inherent mismatch of trying to create daily liquidity in an investment vehicle when the underlying assets are illiquid. It means that the ability to sell may at times be illusory and unreliable.”
After the Woodford debacle, it’s time to make funds safer for investors.