Fund liquidity concerns resurface after limit breaches

by Kyle Caldwell from interactive investor |

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Liquidity is back in the spotlight. Kyle Caldwell explains what it is and why it matters. 

Fund liquidity concerns have resurfaced following data, obtained by Bloomberg, from the Financial Conduct Authority showing that nine funds had breached the 10% limit on unlisted holdings between March and May.

Bloomberg reported that most of the breaches took place in March, during the heavy stock-market falls. In total, the 10% limit rule was broken 13 times. By June, the breaches had subsided. The names of the nine funds were not disclosed.

More attention has been paid to fund liquidity over the past 18 months or so following the LF Woodford Equity Income debacle.

In addition, another closure earlier this year of commercial property funds has kept the subject of liquidity in the spotlight amid debate over the appropriateness of the open-ended fund structure for illiquid investments.

Below, we explain what fund liquidity is and why it matters.

What is fund liquidity?

The majority of funds are liquid, meaning investors should not have any problems withdrawing their money. The fund structure comes with the promise of daily liquidity.

Liquidity is basically a fund’s access to liquid assets, for example cash, or those assets that can be quickly and easily converted to cash without losing value.

Most funds are highly diversified in holding a wide spread of investments that are listed on a stock market, so are unlikely to have liquidity problems.

Why does liquidity matter?

For an investor, liquidity matters because you can end up not being able to access your money. Fund suspensions can be put in place and this has happened on a number of occasions for commercial property funds following Covid-19, the Brexit vote and during the financial crisis. Many open-ended property funds across the sector have been shuttered since March, with several beginning to reopen in the last couple of months. 

In normal market conditions, although it takes months for commercial property funds to buy and sell the shops, offices and factories that are held in the portfolios, it is not a problem for investors to withdraw their cash on a daily basis, as a portion of the portfolio remains in cash, typically 10% to 20%.

But during times of heavy selling, it is a different story, as the cash buffer is depleted. This makes it difficult for open-ended commercial property funds to meet withdrawals on a day-to-day basis.

This is because property sales are not quickly or easily arranged, particularly in times of market uncertainty, and it is therefore very difficult to raise money quickly.

Such a scenario can negatively impact investors who remain in the fund, as the fund manager is forced to sell investments for less than they are worth to scramble together enough money to repay investors who have hit the sell button.

Unlisted holdings are also inherently illiquid, due to not being listed on the stock market. The 10% limit sounds like a small percentage, but the suspension and subsequent closure of the LF Woodford Equity Income fund shows that illiquid holdings can prove very problematic when investors rush to the exit.

Investment trusts do not have this problem. Under the trust structure, a fixed number of shares is issued, raising a fixed amount of money for the manager to invest in a portfolio of assets. Those shares are traded on a stock exchange and their price fluctuates according to demand and supply. But the fund manager does not have to sell or buy shares depending on whether they are attracting or losing investors. This makes trusts a more suitable vehicle to hold illiquid assets and also arguably allows the fund manager to take more of a long-term view in running the portfolio.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

 

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