SCM Direct has called into question how much emphasis financial advisers place on liquidity when assessing fund risk, arguing that a number of IA UK Smaller Companies funds exhibit similar “liquidity mismatches” to those seen across open-ended property funds in July.
However, fund management firms who have been named in the report and impartial investment professionals have disagree with the comparison and, in some cases, argue that illiquidity can actually be beneficial during times of market stress.
The IA UK Smaller Companies sector has proven popular among investors over the years, given its strong track record of returns over the long term.
Performance of sectors over 10yrs
Source: FE Analytics
However, some cautious investors may opt to stay away from the market area, given its potential to be less liquid than vehicles which invest further up the cap spectrum.
An emphasis on liquidity has come to the fore over recent months, given that number of open-ended property funds shut their doors to stem mass outflows following the EU referendum.
In a report yesterday entitled ‘Will UK Smaller Company funds be the next sector to leave UK investors stranded?’, ETF specialist firm SCM Direct – a campaigner for greater transparency – argued that mismatches between underlying liquidity in a fund and an investor’s ability to buy or sell the fund daily need to be addressed by the Financial Conduct Authority (FCA).
While the report acknowledges that FCA chief Andrew Bailey has called for “liquidity mismatches” in property funds to be dealt with, it says that no action has been taken as of yet either to address property funds or, more importantly, other funds in different sectors.
As such, the firm analysed the liquidity of funds across a number of Investment Association sectors, excluding those that whose liquidity-related data was unavailable on Bloomberg and those with AUMs of less than £100m.
Out of the seven equity sectors included in the study, it found that the average fund in the IA UK Smaller Companies sector would take two days to sell their investments if 10 per cent of the fund was redeemed and five days if 20 per cent or more of the fund was redeemed. All other sector averages in the study would take less than one day to sell if 10 per cent is redeemed and one day or less if 20 per cent is redeemed.
SCM Direct also claimed that six funds in the IA UK Smaller Companies sector would take 10 business days or more to meet a 20 per cent redemption, based on the funds participating in 10 per cent of the daily volumes in the stocks held.
| Fund name | Days to sell 20% of fund | Fund size (£m) |
| Liontrust UK Smaller Companies | 29 | 468 |
| Schroder UK Dynamic Smaller Companies | 27 | 434 |
| Schroder UK Smaller Companies | 19 | 581 |
| Schroder Inst. UK Smaller Companies | 12 | 370 |
| CF Miton UK Smaller Companies | 12 | 143 |
| Marlborough UK Micro Cap Growth | 12 | 527 |
Source: SCM Direct, Bloomberg LP
The firm calls these figures “astonishing” and questions what would happen if redemptions even higher than 20 per cent were to occur, arguing that the manager of such funds could try and place large holdings with institutions through a broker rather than sell small amounts through the market each day.
“This might lead to pricing issues as the first holders ‘out of the door’ would receive the current market price for their stocks which could well be far higher than the eventual price received. This might require such funds to suspend dealings to treat all investors fairly,” it warned.
“SCM Direct suggests that this research illustrates the imperative for the FCA to step in where fund’s underlying liquidity does not match the dealing terms offered to investors. Either the investments need to change or the dealing terms need to change.”
However, this view isn’t necessarily shared by other industry professionals.
A spokesperson from Schroders says the fund management house actively manages capacity in all of its funds to ensure its ability to effectively manage these isn’t compromised by taking on too many assets.
Not only this, they point out there are pricing mechanisms in place on all of the firm’s funds to ensure the interests of both redeeming and remaining clients are protected.
“We undertake our own detailed liquidity analysis as part of our processes. In small-cap stocks in particular we often find that liquidity is underestimated for two main reasons; firstly as large holders of stocks we often create liquidity through trading and secondly because trading avenues are available to us which don’t get captured in published liquidity data,” the spokesperson said.
“Therefore, in practice we are often able to trade considerably larger blocks than liquidity analysis alone would suggest.”
The team at Liontrust says the report has a narrow focus in reaching its conclusion for a number of reasons.
Firstly, it points out that the report analyses fund liquidity using techniques appropriate for larger companies with consistent turnover on market. However, the team says that it is commonly accepted among smaller companies investment managers that this doesn’t give an accurate measure of liquidity for funds in their market area.
“Smaller companies' shares generally trade less frequently but do so in higher concentrations of ADV. For example, the average trade size in shares held by [Liontrust UK Smaller Companies] over the last year was 126 per cent of average daily volume,” it stated.
“The liquidity analysis in the report also failed to take into account off exchange traded volume, which in smaller companies can make up a considerable percentage of the total. In short, the report underestimates the liquidity available.”
Secondly, the team says it monitors the fund’s liquidity profile using a combination of measures, which include investor concentration, turnover and investment type, as well as monitoring the liquidity of underlying investments as mentioned above.
Currently, the largest single investor holds less than 5 per cent of Liontrust UK Smaller Companies but the fund can raise over 10 per cent of assets in one day.
A spokesperson from Miton said: “Miton recognises the importance of managing liquidity risk and makes every effort to ensure that investors are aware of the risks of investing in any of the funds it manages including the CF Miton UK Smaller Companies fund.”
“Miton believes that its approach to managing liquidity is consistent with the FCA’s expectations and notes the publication released by them on 29 February 2016 regarding “Liquidity Management for Investment Firms: Good Practice”.”
Given that the fund management houses of the investment vehicles in question are likely to defend their own mandates, we asked a number of independent investment professionals for their views on the report.
Jason Hollands, managing director of Tilney Bestinvest, says that it is self-evident that funds investing in smaller companies are going to be less liquid to funds with high exposure to FTSE 100 stocks, for instance.
Therefore, he argues that in “really, really” extreme market conditions they could struggle to meet redemptions on a daily dealing basis.
However, he says it is clearly not the case that these funds are anywhere near as illiquid as funds invested in physical buildings, which is what the title of the report suggests.
“As anyone who has bought or sold a property will know, it takes some time to complete a property transaction. The SCM analysis suggests that IA UK Smaller Companies funds might take five days to liquidate 20 per cent of their portfolios, which is a lot more rapid than you could liquidate 20 per cent of a commercial property portfolio,” he pointed out.
“So while I agree that these funds could face liquidity pressures in extreme market conditions, that might even theoretically necessitate a temporary suspension of daily dealing to weekly dealing, the proof of the pudding is in the eating: in the aftermath of the EU referendum when investors were panicking out of UK assets, much of the commercial property fund sector ended up suspending dealing, while IA UK Smaller Companies funds were able to stay open. This was also the case in the aftermath of Lehman going bust eight years ago.”
Ben Willis, head of research at Whitechurch Securities, remains positive on UK smaller companies over the long term because of their capital and dividend growth potential.
When it comes to illiquidity, he says it can actually be an investor’s friend during times of market stress, as the liquid large-cap stocks that get sold off quickly are the easiest to trade.
“We witnessed this in August last year when China weakened its currency and market acted adversely. The FTSE 100 sold off aggressively whereas as UK smaller companies held up well,” he pointed out.
“In addition, even though some smaller company funds are relatively illiquid, they can still meet redemptions as, unlike property, they do not have to sell down physical assets.
“Overall, an element of liquidity risk is accepted as part of investing in UK smaller companies and it only becomes a significant problem for us if a fund is too successful, attracts inflows and then has to close due to size. This is because we run discretionary managed model portfolios and so if a fund is closed to new monies, we have to sell it regardless.”