How do you solve a problem like fund liquidity?

Proposals for a new type of fund are acknowledgement of the structural advantages of investment trusts.

The Investment Association (IA), the trade body for the fund management industry, has come up with its solution to solve the liquidity problems that can negatively impact investors in open-ended funds.

The proposal on the table, the details of which we explain in more detail here in our accompanying news article, is a new type of open-ended fund structure, which will be called a long-term asset fund.

The basic principle is that this type of fund will facilitate investments in illiquid assets, such as property, infrastructure, private equity and private debt. To provide a better structure for these investments, the fund will be able to receive new money to invest, but investors will not be able to sell their holdings on a daily basis. Instead, investor redemptions will be facilitated at "appropriate time intervals", says the IA. 

Limiting withdrawals will help avoid a scenario that saw Neil Woodford make his way from the personal finance pages to the great pedestal of airtime of national news earlier this month, when he moved to suspend his LF Woodford Equity Income fund.

The investments he is offloading are unquoted shares (in private companies that are not listed on a stock exchange) and therefore not easily traded, so the fund has been closed to give Woodford some breathing space.

The IA's idea is a sensible one, as this proposed new structure will protect investors under a scenario where there is a 'run' on the fund – a large number of investors asking for their money back at the same time.

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

But the proposed new fund structure is not one that retail investors are going to be able to easily access, with the IA saying it is unlikely to be offered in the mainstream retail fund market without requirements for advice or appropriateness tests. Instead, the IA is hoping the new fund structure will attract the interest of defined contribution pension schemes.

These are still early days, but my opinion is that well-informed self-directed investors should be able to buy if they wish. Yes, liquidity risks push these funds higher up the risk spectrum, but providing investors understand how the funds operate in regards to how they invest and the limitations that will be imposed on when they can withdraw their investments then I really don’t see why they should be barred.

If these funds cannot be bought, then investors have a solid alternative to fall back on – investment trusts.

In fact, the main structural advantage investment trusts have is a fixed pool of assets, for which a fixed number of shares is issued, raising a fixed amount of money for the manager to invest in a portfolio of assets. This is the reason why the investment trust form is much more appropriate for holding illiquid assets than the use of open-ended funds.

The IA's new fund structural proposals seem to offer investors some sort of halfway house between open-ended funds in their current form and an investment trust, as they are seeking to limit daily withdrawals, but without putting a limit on how much can be invested on a daily basis.

But for those investors who want to ensure a fund manager is not forced either to sell or to buy shares depending on whether they are attracting or losing investors, the investment trust structure is still the only option.

Open-ended funds are also seeking to become similar to investment trusts in another way. From September 2019 all asset managers will be required to have at least two independent directors on their boards, and these independents will have to comprise at least 25% of the board.

As Rebecca O'Keeffe, head of investment at interactive investor, Money Observer's parent company, points out:

"Given that the proposed long-term asset funds are able to limit withdrawals to brief windows that open every month/quarter, investors will reasonably ask: ‘What do I get in exchange for this lack of liquidity?"

She adds: "It is arguable that illiquid assets would be more sensibly packaged in closed-ended investment trusts which do not need to respond to demands for redemption. Instead, the Investment Association is attempting to create a new hybrid open-ended fund structure, one that oscillates between lock-in periods and redemption periods."

• Neil Woodford fund closure highlights key investment trust advantage

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