Should investment funds face bank-style stress tests?

After the Neil Woodford scandal, and now the suspension of the M&G Property Portfolio, Hannah Smith discusses how we might avoid further fund upsets, and the benefits of the investment trust structure.

Investors trapped in the beleaguered Woodford Equity Income fund were hoping that the shuttered fund might reopen in December and they could get their money back. But instead of a Christmas miracle, they’re getting a lump of coal in their stocking, with heavy losses likely as the fund is wound up.

This case has shocked the fund management industry, and raises the question of whether funds should face bank-style stress tests to make sure they can meet redemption requests in falling markets.

Neil Woodford’s case was unusual, in that his problem was unquoted stocks becoming too large a part of the fund, but it certainly highlights the fact that the industry could pay closer attention to liquidity.

The issue is even more pertinent after a decade-long bull market, during which some active funds have grown very large while a passive-investing boom has seen explosive growth in exchange-traded funds (ETFs). If the market turns and investors head for the door in droves, how will these Goliaths cope?

Brexit could even be the catalyst. Several open-ended property funds suspended dealing in 2016 as investors panicking about the EU referendum result pulled £5.7 billion from portfolios. Could the same happen again when Britain finally leaves the EU?

• Investment trusts and the income safety net
• M&G suspends £2.5 billion open-ended property fund

Industry watchdog the Financial Conduct Authority (FCA) has brought in new rules for some types of open-ended funds investing in illiquid assets such as property, to give investors clearer warnings about the risks involved. But Ucits funds (such as Woodford’s) already have restrictions in place as to how much of their portfolios they can hold in illiquid assets – and those limits are clearly not always enough to protect investors.

Another idea comes from industry body the Investment Association, which has proposed the creation of “long-term asset funds”. This new fund structure would give investors access to illiquid assets such as private equity, real estate and infrastructure, while allowing managers up to two years to meet redemption requests “to reflect the time it takes to sell these investments”.

Fund buyers’ tests

Most professional fund buyers already conduct their own stress tests on the funds they buy, as part of their regular due diligence. Greystone Wealth Management’s head of multi-asset, James Menzies, asks third-party fund managers to supply data on how long it would take them to sell all their assets under different assumptions of “stressed market conditions”. This information allows him to build a liquidity profile of the funds he holds.

But there isn’t a formalised, standardised process across the industry for voluntary stress-testing of funds. Bank of England governor Mark Carney wants to apply industry-wide stress tests because he says more than half of funds have a “structural mismatch” between the frequency with which they offer redemptions and the time it would take them to sell assets. The Bank fears this could result in firesales and amplify market swings.

But industry experts suggest Carney’s tests would be based on backward-looking data, reducing their effectiveness. “The risk is that any analysis of this type will always be based on scenarios and assumptions derived from past data, which need not be repeated,” says Menzies.

“Even the Bank of England’s own stress-testing scenarios heavily refer to the events of the global financial crisis. Although Woodford IM was newsworthy, it can be argued that the fund was not typical of its sector because it had high exposure to very early-stage companies and illiquid stocks, and so it makes a poor case study on which to base any new regulation.”

Following Woodford’s suspension, research house Square Mile also looked again at the liquidity profile of the funds it covers, says the group’s head of research, John Monaghan. He notes that databases and systems already exist to calculate how long it would take to redeem a certain proportion of a fund.

Fixed-point databases

“The issue is that a lot of these databases are obviously only a fixed point in time. They’ll be backward-looking. They don’t take into account things like ‘dark pools’ and other off-exchange type trading activity, which is quite a big part of the market nowadays,” he says. He points out that 30% of trading is now done ‘off-market’ rather than on direct exchanges, which means that “in actual fact, liquidity is probably higher than we’re led to believe”.

Another potential problem with a mandated approach to liquidity management is that it would force fund managers to change the way they invest to meet these restrictions. “A prescriptive approach has the potential to lead to worse client outcomes overall, as asset managers are forced to buy assets that they wouldn’t otherwise in order to meet liquidity targets,” says Menzies.

The gated commercial property funds are a good example of this, he adds, as many are now sitting on large cash balances in case they have to meet future redemptions. This will be a drag on performance, and means investors are paying active management fees to have a big chunk of their money held as cash on deposit instead of in commercial property.

Trusts have the edge

Some commentators have suggested that stress-testing is not the answer, and that in fact illiquid assets are better held in closed-ended vehicles whose structures are more suited to this type of investing.

James Carthew, head of investment company research at Marten & Co, argues that open-ended funds should be banned from holding illiquid assets altogether.

“We’ve been fairly strident in saying we don’t think you should hold any illiquid assets in open-ended funds,” he says.

“That definitely goes for the property funds. They just shouldn’t exist. If [asset management groups] just convert them all into real estate investment trusts, the problem goes away and investors are much better protected. We don’t understand why the FCA won’t make that move.”

Carthew flags up the possibility that small-cap and micro-cap open-ended funds could be the next ones at risk of liquidity problems if sentiment suddenly shifts. “If you’ve got a fund that’s holding a lot of very small companies and then you suddenly get a big redemption, it’s quite hard to turn that into cash.

“If you want to invest in those sorts of things, it’s a much better idea to go for the investment trust structure,” he says.

Investor education

Instead of regulatory intervention, Monaghan argues that changing investor behaviour through investor education is a better way to prevent another Woodford-type debacle. He says that fund groups must try to strike the delicate balance between maintaining daily liquidity in their funds and reminding investors that collective investment schemes are intended for the long term.

• 10 most-popular investment trusts – November 2019

“We ought to be in a situation where individual investors aren’t buying one day, selling the next. They have to understand, probably through appropriate advice, that it’s a three-, five-, 10-year investment,” he argues. “Obviously situations change, and sometimes investors are going to need their money back, but there has been some commentary in the industry that mutual funds are now being treated almost as cash machines, and that there’s not a full appreciation of a longer-term investment horizon. That said, funds are daily-traded vehicles. The liquidity has to be there. I think it’s a difficult one to try and get regulation around.”

Why investment trusts have a liquidity advantage

Investment trust managers don’t face the same pressures of managing redemptions as open-ended fund managers as trusts are closed-ended (they issue a fixed number of shares). If investors want out, they just sell their shares at the market price. Open-ended fund managers, however, have to sell holdings to meet withdrawal requests, and might not always be able to sell quickly or at the right price.

So how would each type cope if a swathe of investors headed for the door at once? A trust is a listed company, so any significant outflow would be reflected in the bid/ offer spread – the difference between the price at which you buy and sell shares. Brokers or market makers could apply a wider bid/offer spread to discourage people from moving out, so they themselves wouldn’t be left holding too many unpopular shares, explains Monaghan.

On the open-ended side, a daily-priced unit trust could apply a dilution levy if high levels of buying and selling or one large withdrawal looked likely to push up dealing costs and affect the value of the fund’s holdings. Funds can also be gated or suspended to give the manager time to sell holdings, or investors can be forced to take a ‘haircut’ or writedown to withdraw their money.

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.