The basic problem here
We know, or at least should know, the problem with liquidity mismatches. It’s, in an economic sense, the big problem that was identified with WeWork. They had $47 billion in long term rent commitments. But they were turning around and renting out that property to people who could, often enough, leave with a month’s notice. That’s a big liquidity mismatch.
Or, the more normal banking problem. Most deposits at banks are short term to on demand. Most lending out by banks is on longer terms. It’s that scene from A Wonderful Life:
And as 2008 showed us, liquidity mismatches are dangerous.
The specific problem
More recently we’ve seen the growth of open ended funds investing in illiquid assets. Property funds in 2016 came a cropper doing this:
There is a worrying whiff of investor panic in the news that a £2.9bn retail property fund has suspended redemptions. Retail investors had been rushing to cash in units in Standard Life’s UK Real Estate Fund in the wake of the Brexit vote. The asset manager was forced to slam its gates in their faces today to protect the interests of all unit holders… Private investors favour open-ended funds for imagined low costs and flexibility. However, the funds lack the latter characteristic when dealing in illiquid investments, such as the commercial property that is the metier of the Standard Life vehicle. You cannot deal fast and in size in office blocks, as you can in blue-chip shares. Old-fashioned closed-end funds and real estate trusts have the virtue that investors can dump listed stock without making a call on underlying investments.
If it takes a few months to shrink a fund by selling property then it’s difficult for that same fund to be able to offer investors the opportunity for immediate withdrawal. At least, if a substantial number wish to withdraw there are going to be those problems with liquidity.
We’ve also had a more recent example, as I detailed here, with a bond fund:
Open-ended bond funds provide daily liquidity for investors but are increasingly investing in longer-dated or lower-quality securities as bank regulation has reduced the supply of market liquidity and investors are seeking extra yield while interest rates remain low. This exposes funds to liquidity pressure if there is a spike in redemptions, potentially leading to forced asset sales and a run on the fund as investors pull out. The risks are most pronounced in purely credit-focused funds with less-liquid underlying assets, such as corporate loans and bonds. We estimate pure credit funds are about 15% of total global bond funds.
And then there’s Woodford
Then there’s that Woodford Patient Capital fund. He’s invested into illiquid stocks and private companies. He was offering investors daily exit opportunities. So, clearly, when that became a wave of redemptions there was a problem. The fund had to close to redemptions. Which isn’t really the point for investors now, is it? Who will have invested in what was promised, the possibility of redeeming as and when they wished to.
So, there has to be a solution
One obvious one is simply for no one to invest in open ended – closed end would still be fine as they’re not offering that liquidity mismatch – funds in illiquid sectors. Use, perhaps ETFs, closed end funds, or simply avoid altogether.
Or, some form of regulation so that at least everyone knows what the game plan is when going in.
The new regulations.
Which is exactly what we are getting, new regulation of open ended funds. Which is possibly righteous but it does make such funds less attractive for us:
The UK’s financial regulator has published new rules designed to prevent a repeat of the shutdown of open-ended real estate funds in 2016.
The Financial Conduct Authority (FCA) has confirmed a number of measures, including requirements that open-ended funds that invest in illiquid assets must suspend dealing when “there is material uncertainty regarding the value” of more than 20% of assets.
Don’t forget, the only dealing in an open ended fund is with the fund itself. Thus if there is such a suspension investors are locked in.
The liquidity mismatch is something that has worried for some time – as you can see above. I’ve been saying that it is such a problem that investors should steer clear perhaps. Not of the underlying sectors, but of that specific form of investing in them.
This change in regulation simply reinforces that. The possible loss of liquidity is a high price to pay. So, find another method of investing.
The investor view
Open ended funds are potentially dangerous to us as investors because we can be locked in just when we’re looking for liquidity. There do have to be regulations about this in the presence of price uncertainty.
However, these new regulations mean that end to liquidity can come even when there is no liquidity problem, but when there is just and only that price uncertainty. This is a loss to us as investors.
After all, liquidity is valuable to us, that’s why the attraction of traded funds rather than direct investment itself. We’re losing some of that value, or at least risk doing so.
My opinion is that open ended funds are now something to avoid unless the underlying is near as liquid as the terms on offer to us investors. So, if we agree to lock ins – as with VC funds and the like, even to term CDs – then that’s fine. Equally, something like a tracker fund in major equities has the same or even more liquidity in the underlying than is on offer to us as investors in it. But near anything offering us more ability to exit than is possible in the investments themselves is, to my mind, to be avoided.
If we desire exposure to those sectors then closed end funds seem more prudent.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.