Investment industry professionals are concerned about the suitability of the open-ended fund structure for inherently illiquid asset classes such as infrastructure and property, and are calling for the regulator to review how these products are sold to retail investors.
Issues with fund liquidity have come to the fore in recent months and have already forced regulators to tighten their grip on fund providers, with European body Esma recently announcing stricter liquidity stress tests for investment funds, set to come into force in September 2020.
Most recently, the discussion has been driven by the shock suspensions of the Woodford Equity Income fund and an absolute return bond fund run by GAM, as well as the downgrade by Morningstar of the H2O Allegro fund on concerns over illiquid and risky holdings.
The FCA has been dealing with this issue for some time and has undertaken two consultations – one on illiquid assets and open-ended funds in response to property fund suspensions in 2016, and one on so-called patient capital.
Matthew Priestley, director at Governance Connect, says: “The FCA is concerned that alternatives are going into the retail space, but retail clients don’t understand them. And they are right. These assets are essentially illiquid, but wrapped in a liquid wrapper. But these funds can be useful for retail investors if they are sold in the right way.”
Cedric Bucher, chief executive at Hearthstone Investments, believes it is time to take a step away from the industry’s obsession with daily liquidity and instead find a structure for more complex investments which fits the assets being held in the fund, which are often far less liquid than the Ucits fund structure entails.
“Ucits has been built as a retail format for investors who potentially don’t have a financial adviser, and as such these funds should be highly liquid and transparent. The industry is trying to bring alternative investments to the world of retail by using this retail structure, but it is putting investments with limited liquidity and transparency in the wrong wrapper,” he says.
Commenting on the Woodford scandal, Bucher adds that the issues faced by the manager could have been avoided if his fund was sold in a different structure: “It should have been labelled patient capital for a ten-year investment horizon, otherwise investors shouldn’t touch it. It was venture capital stuff.”
Priestley believes that while illiquid products are necessary to provide retail clients with diversification and volatility management tools, they must come with a “health warning”.
“It should not be a negative if a fund is called a complex vehicle, as this just means more understanding is needed to make sure the product is appropriate,” he says. “This would also help to build up trust, manage expectations and with retention of the product.”
Lessons from Abroad
Looking at open-ended property funds in particular, which experienced a crisis in the UK following the Brexit vote in 2016 when many funds were forced to suspend dealing due to high levels of redemptions, Bob Steers, co-founder of Cohen & Steers, has called for the FCA to consider the example of the US and Germany.
In the US, open-ended bricks and mortar property funds only allow redemptions monthly or quarterly, which has meant that just six such funds have suspended redemptions since 1972, he says.
Meanwhile, the regulators in Germany, which suffered its own problems in the sector during the global financial crisis, have responded by removing daily dealing and introducing a two-year initial holding period on property funds, with a one-year notice period for redemptions.
“Now is the time for the UK regulator to act,” Steers says, while Bucher agrees the German model would be a “useful piece of regulation” in the UK.
However, a move away from a Ucits fund structure could spell bad news for model portfolios, which rebalance on a regular basis – an issue many have already faced as a result of the suspension of Woodford Equity Income in June.
While financial advisers managing money on a bespoke basis for clients are able to place illiquid holdings in a segregated mandate and trade around it, model portfolios must be able to rebalance all holdings at the same time. Bucher suggests an answer may be for advisers to build two types of model portfolios – a liquid model and a “patient capital” model, which would hold less liquid funds.
However, there are other reasons that the Ucits format remains attractive such as the common legal framework it offers, points out Daniel Elkington, independent financial planner at MT Financial Management. “The reason we like the traditional Ucits-style wrapper is that when we are comparing similar funds, there is a common legal framework which takes away a lot of due diligence requirements,” he says. “We don’t want to spend time examining the legal structure instead of focusing on investment decisions.”
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