The spotlight on liquidity issues in open-ended funds has not diminished over the weeks following the gating of Neil Woodford’s flagship LF Woodford Equity Income fund. With attention now being placed on liquidity, Gresham House’s Ken Wotton says investors should keep in mind five key liquidity rules for owning small-caps. 
“While stocks at the smaller end of the equity market often exhibit lower levels of liquidity than larger peers, it must be remembered small- and micro-cap stocks are less liquid – not illiquid,” said the lead manager of the £173m LF Gresham House UK Micro Cap fund.
But Wotton (pictured) added that just because micro-caps are less liquid, it does not mean that it takes less management.
In fact, it is a crucial step to achieving a good long-term performance as well as meeting investors’ needs.
“Liquidity matters at a stock level,” he said. “For building and exiting positions, as well as delivering target returns. More importantly, liquidity in open-ended funds allows investors to deal on a daily basis.
“In open-ended funds, the manager takes responsibility for this risk.”
The first rule in managing that risk is being ‘capacity aware’.
According to Wotton, this means outlining and maintaining the amount you are willing to be invested in.
“The key starting point to delivering attractive long-term returns is having a clear understanding of the capacity of an investment strategy,” he explained.
“We strictly adhere to this and do not raise more money for a vehicle than we believe we can effectively manage. We have clearly communicated the capacity constraints of our small- and micro-cap strategies to investors.”
The next rule is another building and maintenance task but this time with regard to relationships.
“We have been investors in less liquid listed companies for well over a decade,” said Wotton. “We undertake our own dealing, which requires maintaining direct relationships with sales traders at every broker of small- and mid-caps. This can be key when trying to achieve liquidity at the smaller end of the market.”
These relationships, built up over time, are a key element to Wotton because he sees that it is from those conversations that a thorough market understanding is developed. And that is crucial information for informing managers decisions, particularly around exiting and entering a fund.
He said: “Modelling returns for individual stocks must consider assumptions of entry and exit prices, factoring in appropriate liquidity adjustments where relevant.
“As investors, we must form a judgement as to the likely liquidity for both entry and exit, taking into account historical trading volumes and size of free-float. We also need to assess the shareholder register and build a detailed understanding of the market through discussions with trading desks at the relevant brokers.”
But once it has been decided which funds you are going to cash out of or buy into small- and micro-cap investors have to decide how big a place is that going to hold in your portfolio.
Position and sizing of the illiquid and less liquid stocks within a portfolio have been some of the biggest discussion points since the fallout of the Woodford gating.
The realisation of the immense impact an overweight in illiquidity or less liquid stocks can have across the portfolio has been a big lesson for managers and investors to learn. Now making it a “crucial component” to Wotton’s process and methodology.
The fifth and final rule from Wotton is placing “liquidity buffers” onto your fund.
The idea of a “liquidity buffer” - also called a liquidity cushion – is when a company holds a certain amount of cash or another highly liquid asset, used to meet an unexpected, sudden rush for cash from investors to help avoid a liquidity crisis.
In his own portfolio, Wotton said that he operates on a minimum cash level of 5 per cent of the net asset value (NAV), going up to a maximum of 10 per cent, Currently, the five FE Crown-rated LF Gresham House UK Micro Cap fund holds 6.5 per cent of the portfolio in cash.
“Our funds also have access to a short-term borrowing facility of up to 10 per cent of NAV, allowing material redemptions beyond the available cash to be met in accordance with daily dealing,” Wotton said.
“Moreover, portfolio construction explicitly takes into account liquidity, seeking at all times to balance less liquid holdings with more liquid holdings.”
In addition, internal and cornerstone investors form a core part of the fund helping to provide a layer of sticky patient capital and ensuring available liquid assets are maintained at a prudent level.
He concluded: “Liquidity is a core component of our investment process when selecting stocks, determining target returns and formulating portfolio weightings.
“We also actively monitor liquidity at an aggregate portfolio and fund level, and it forms a key measure for risk monitoring and oversight.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
The LF Gresham House UK Micro Cap fund, co-managed by Wotton and deputy manager Brendan Gulston, was launched in May 2009.
It has made returns of 338.48 per cent since launch against a 288.25 per cent gain for the average IA UK Smaller Compan