They say that all publicity is good publicity. How blessed Neil Woodford must be! Shock horror, an open-ended investment company has gated (stopped investors selling or buying). The reason being liquidity, or lack thereof, in shares. Everybody knew that there was a possibility of a fund being gated if it was invested in the likes of bricks & mortar, but in shares, that had never happened before. 
Well actually it had. When you’re as old and wise as me, you feel that you’ve seen it all before.
Judging by the reaction of the regulators their collective knowledge seems to be limited to one decade or so. If it hadn’t been so limited, they may have replicated the reactions seen in the past that had allowed small investors to sell out.
When did it happen before? In the Asian financial crisis, the Fidelity ASEAN fund was not able to deal in its Malaysian holdings as capital controls were imposed on the ringgit, and Singapore closed the OTC (over-the-counter) market in Malaysian shares. The solution back then was to split the fund in two: the rest of the south-east ASEAN markets in the old fund, and a new fund which held just the Malaysian stocks. This enabled smaller investors to get some of their money out if required. Eventually the fund with the Malaysian Holdings had a value as the crisis measures were unwound.
With the current Oeic (open-ended investment company) structure it would be quite simple to create a new share class which just held the unquoted and illiquid assets in Woodford’s fund. He would then have as long as he needs to sort out this new fund and in the meantime the old fund can be run as a traditional UK equity income fund, and investors could buy and sell it as they liked.
As always happens in a ‘crisis’ we see the plethora of knee-jerk reactions by various ‘experts’. Even the Investment Association has helpfully introduced the idea of a new ‘long-term assets fund’, which will not have daily dealing. One can only imagine the confusion this new vehicle would create for both retail investors, and for anyone using a platform.
Believe it or not, the reason why we have Oeics is because unit trusts were not allowed to have single pricing, which many fund managers wanted to have in order to sell their funds in Europe. Not a lot of people would remember that, least of all the ‘experts’ supposedly running the industry. Some have suggested that closed-ended funds (investment trusts) are the answer. In some respects they could be right. However, having tried to sell £25,000 worth of an investment trust in the morning of 19 October 1987, which was before the US market had opened, finding a bid was virtually impossible.
One has to ask oneself how the regulators, who have been ‘closely monitoring Woodford’s fund’, were allowing some of his unquoted securities to be listed on the Guernsey stock exchange in order to get around the 10 per cent in unquoted shares rule. What ever happened to the concept of abiding by the spirit of the law/rules.
One of the problem with our regulators is they have the uncanny knack of shutting the stable door after the horse has bolted. Most industry participants will be able to come up with their own examples of this. Even simple things like the FSA (the Financial Conduct Authority’s predecessor) still showing on their website that investment trust zeroes (zero dividend preference shares) were low risk after the investment trust cross-holdings problems blew up in the early noughties. The mantra of “in doubt, do nought” is probably quite descriptive of current thinking when something isn’t in the rules. How else can one explain that, when the FSA/Bank of England/HM Treasury in November 2006 had their ‘war game’ on a collection of banks, which showed that the UK government’s investor compensation scheme was inadequate and could too easily cause panic, and that Northern Rock, one of the banks assessed in the ‘war game’, were running high-risk funding strategies, they did nothing. It’s not just the regulators. What’s the point of having a rating agency that de-rates the fund once it’s been gated?
For the past year, the question of liquidity in open-ended funds has been targeted at those invested directly into property. However, a cursory glance at the composition of the majority of these funds shows weightings of cash in excess of 20 per cent. This has been building as the respective fund managers are protecting the funds from being gated in the future in the event of a ‘no deal’ Brexit having a negative impact on the commercial property sector. From a portfolio construction point of view, property held in an open-ended investment company has provided a reasonable return with a low level of volatility. Unfortunately, volatility has become the main measure of risk when comparing portfolios and funds across the industry. The problem is if your bricks & mortar fund has 25 per cent in cash, on which you’re paying a fee, and future returns are expected to be flat, even from a portfolio construction point of view it becomes debatable.
At the Bank of England inflation report to the Treasury Select Committee at the end of June, chair Nicky Morgan asked the representatives from the Bank of England whether Woodford’s fund’s gating had lessons for financial stability or wider trust issues within the industry. John Cunliffe said it was a systemic issue but a global issue. Mark Carney said this was a big deal and something that he and Sir John had been raising internationally since 2015. Carney said “these funds are built on a lie” where they suggest you can have daily liquidity for assets that aren’t liquid. This creates an expectation that you can have your money back just like from a bank. Strange that he said that since Northern Rock, a bank, demonstrated that in the financial system there are no guarantees of liquidity. Carney highlighted funds that were invested in leveraged loans, high yield debt, and emerging market debt. There is little doubt that the corporate fixed interest market is an area where liquidity could dry up very quickly if investors decided to withdraw. This debt is dealt over-the-counter with dealers whose liquidity has been reduced as regulators have demanded higher capital adequacy. Ironically, it isn’t open-ended investment companies, which as we’ve seen can stop redemptions, which are likely to be the problem. It is more likely to be exchange-traded funds (ETFs) where investors are not just looking for daily dealing, but instant dealing.
Having witnessed the actions of investors as the financial crisis unfolded the majority are not as stupid as our regulators assume. At the time many with funds in a bank in excess of the financial compensation scheme were moving monies into other banks. The response therefore to the liquidity mismatch in open-ended investment companies from regulators is to ensure that investors are made aware that there could be times when they will not be able to get their money out instantly. Caveat emptor. From regulators’ point of view globally, they should be working out what they do about the big debt ETFs, because they could create a systemic problem and could need access to central bank money just like the banks did in the financial crisis.
Paul Warner is senior portfolio manager at MitonOptimal. The views expressed above are his own and should not be taken as investment advice.