Open-ended emerging market equity funds “will only end in disaster” according to star manager Terry Smith, who believes it is “irresponsible” to hold shares with limited liquidity within a daily-dealing OEIC.
The manager, whose flagship Fundsmith Equity fund is £10.3bn in size, believes emerging market equities offer significant growth prospects due to attractive demographics and increasing consumerisation, which is why he decided to launch Fundsmith Emerging Equities Trust back in June 2014.
Performance of trust vs sector and benchmark since launch
Source: FE Analytics
While Fundsmith Equity is open-ended, he decided to launch the strategy in a closed-ended vehicle and warns that investors could be taking on far more risk than they realise by buying into emerging market OEICs. 
“In my view, it is irresponsible to buy things with limited liquidity in an open-ended vehicle, our main fund is an open-ended daily-dealing OEIC,” Smith (pictured) said. “You can give us a call at lunch time if you want to put any money in or take money out, you can do that.
“If you use that kind of structure with underlying illiquidity, it will only end in disaster. Sooner or later everyone will head for the exit at the same time and you will be unable to satisfy them. Look at what happened to the UK property funds after Brexit, they were universally gated because they couldn’t provide the sensible liquidity.
“You shouldn’t combine assets of that sort which are, by definition, illiquid in open-ended structures. So, we launched a closed-ended fund to pursue the strategy.”
According to data from FE Analytics, the IA Global Emerging Markets sector has more than £47bn worth in assets under management held across 89 open-ended funds. In contrast, the IT Global Emerging Markets Equities sector has just £5.3bn assets under management spread across 10 trusts.
Are investors taking on additional liquidity risk in holding open-ended emerging market funds that they haven’t bargained for?
Ryan Hughes, head of fund selection at AJ Bell Investments, believes that claiming emerging market OEICs are “a disaster waiting to happen” is perhaps a little strong.
However, he warns that investors do need to be aware of liquidity risk in any investment they buy into.
“In an open-ended fund, investors can get their capital back when they like and that can create selling pressure for the manager, who may have to raise capital to repay those investors in an environment which is challenging,” he explained.
“That’s always a problem when running open-ended strategies, regardless of whether it’s investing in emerging market equities or UK equities.
“I don’t see it as a disaster waiting to happen, but I think you do need to go into this with your eyes open and understand the potential risk that, if managers have to raise capital they may not be getting perfect pricing to do that.
“That can be mitigated somewhat by using the closed-ended structure, but of course there the problem is that, in the same scenario, they can move to a discount. So, you create a different problems which can be equally painful for investors.”
Hughes says the trust structure creates additional certainty for the manager as they have a captive pool of assets. However, he says all this really does is shift the problem onto the end investor.
“What we’ve seen over the years is these trusts can move to significant discounts. Effectively, you’ve given up some of that underlying capital that you originally put in, so you need to be careful,” the head of fund selection continued.
“It’s more about where it shifts the risk to and, from an investor perspective, as always, understand the different risks that different structures bring and understand how you can mitigate those if you want to.”
According to AIC data, the average global emerging market trust is trading on a hefty 10.7 per cent discount to NAV. In terms of valuation risk excluding discount, there is little different between closed-ended and open-ended emerging markets funds, with the average ongoing charges figure (OCF) of the former at 1.26 per cent and the latter’s OCF average at 1.17 per cent.
Closed-ended emerging market funds do have a slight edge over open-ended funds when it comes to risk metrics though. The average emerging markets trust has an average five-year annualised volatility of 12.41 per cent while the average emerging market fund has an annualised volatility of 14.3 per cent.
That said, both have a very similar maximum drawdown (which measures the most money lost if bought and sold at the worst possible times) of around 20 per cent over the same time frame and there is a less-than one percentage-point difference between their average total returns.
Neil Jones, investment manager at Hargreave Hale, says that while there are pros and cons of closed-ended funds, he believes they are highly advantageous and almost essential in cases where the underlying asset is illiquid or volatile.
“We have seen this clearly over recent years in the property sector, whereby many leading fund houses had to refuse redemptions as they would not be able to realise sufficient cash quickly enough,” he said.
“An added issue, which I don’t feel was covered sufficiently at this time, is that in order to cover the possibility of large redemptions, these funds were carrying circa 10 per cent in cash, which effectively was generating a near-zero return, leading to a massive performance drag.
Performance of sector over 10yrs
Source: FE Analytics
“In fact the cash drag can be a similar hindrance during good times, as if money is flowing into the sector it can’t necessarily be invested very quickly.”
Jones says the closed-ended structure works much better in these scenarios as the share price trades independently to the asset value, so there is no requirement to meet redemptions and sell assets at short notice.
As such, he says it allows the fund manager to focus on maximising a return from assets and remain fully invested. In terms of discounts, he points out that over time these tend to return to NAV.
“Although the emerging market sectors have grown over the years, they do remain relatively illiquid and often highly volatile, both of these factors could cause difficulties for fund managers if there is a sudden change of sentiment in the sector,” Jones warned.
“The finite number of shares on offer also means there is less pressure on the managers to spend time marketing, so allowing them to focus on the day job of investing money, plus there is the ability to increase gearing, which can potentially enhance returns.
“The main downside is that investors can see the share price fall irrespective of the asset value, if the investment trust moves to a discount, something which can be very frustrating. Of course, if you are able to buy at a discount, then this can enhance returns for the investor.
“In addition, although the investment trust structure solves the problem where the underlying asset is illiquid, it can have liquidity issues of its own, depending on the size of the fund and the transaction in question. As with any traded company, supply and demand ultimately dictates the price.”
That said, he believes these negatives will be more than outweighed by a trust’s advantages. He believes that not forcing the fund manager to either buy or sell underlying assets simply because of inflows and outflows will help performance.
“Just be mindful of the current discount and where this stands in relative terms to its normal trading range, as this can make a considerable difference to your return,” he added.
Simon Evan-Cook, senior investment manager of Premier multi-asset funds, says that it depends on the individual investment vehicle as to how liquid it is.
“As with most things, I think it's wrong to apply a blanket generalisation,” he said. “We need to be careful with some smaller, less-developed markets, which is why we only access frontier market strategies through closed-ended funds.
“But most all-cap managers are aware of the liquidity constraints of their markets, and position their funds accordingly. The biggest test for them, and most funds, was the financial crisis in 2008, and there were no problems for mainstream global emerging markets funds through that period.
Performance of sectors vs index over 10yrs
Source: FE Analytics
“It's hard to imagine a more effective stress test than that, so we have confidence there's no liquidity issues in the open-ended funds we own.”