How should investors view fund liquidity? After an unexpected high-profile fund gating, this risk is now front-of-mind for advisers and clients. More regulation lies ahead, but debate is needed. There is a danger that the wrong lessons will be drawn from recent events.
Stockmarket liquidity ebbs and flows, with wider sentiment often exaggerating investor pressure on funds. When money is flowing in strongly, liquidity is usually good in funds and in the broader market. First questions are: is the fund vehicle well-matched to objective and strategy; is the investor horizon in line with the likely timeframe of investment and underlying liquidity; and has the manager put any capacity limits in place that recognise the investible universe and likely liquidity in that? The issues are not just from small companies, or private companies – unquoteds. Big percentage holdings matter whatever the company size.
A fund manager should also be able to demonstrate to clients that processes are in place to monitor liquidity, that information must go to the portfolio managers responsible, and also to independent governance. The emotional conflicts involved mean that intervention comes not just from those with regulatory responsibility, but also from directors largely independent of the commercial income streams involved. A fund authorised corporate director (ACD) has serious responsibilities, but typically also is paid fees from a fund that grow with the size of the fund. What makes absolute sense commercially, may not be appropriate as a whistleblowing mechanism. This should be borne in mind when an ACD revalues upwards an unquoted portfolio holding in a fund.
Some fund managers have decided to avoid unquoted holdings, despite the growth potential these may have or even an apparently imminent IPO. This recognises that it is an area of specialist expertise. The timescales, vehicles, and client expectations and communications are all different from listed investments. And the inherent conflict in an open-ended fund - where a manager must have confidence over valuations and liquidity as a fund experiences inflows or outflows - is hard to manage. Managers themselves are conflicted in this - putting a lot of responsibility on the ACD, compliance and governance. It is difficult to accommodate departing shareholders without forcing remaining investors to hold more of an unquoted. The funds are designed to scale up and down, but unquoteds cannot do this readily.
Of course, even with a policy to avoid unquoted investments, a manager still needs to maintain a fair value process as from time-to-time companies will be suspended, markets closed for the day, or collapsing liquidity requires a stock price adjustment. In practice, few managers and ACDs are structured to provide daily oversight of this process.
Liquidity monitoring should be firm-wide – there is little value in knowing that an individual fund’s position is liquid to the desired degree if that information is not combined with all the similar holdings in other funds run by the same manager. This points to the dangers of scale. In the drive for harmonisation of portfolios within the same investment firm - and in wealth managers across all clients with similar objectives - stock concentration has been encouraged. At the same time, the largest capitalisation, most liquid stocks, have been disappointing – over the very long term outperformed by the indices of mid-cap companies. Diseconomies of scale, disruption, globalisation, low productivity and disinflation may all contribute to this.
It does mean that managers tend to look to less liquid stocks for performance. Liquidity may normally be reasonable in these - but it will not be the liquidity of the largest FTSE 100 companies. And, for some companies that continually raise money liquidity may be patchy, with a changing shareholder register and lack of broad analyst coverage. All of these suggest that investment firms should set capacity limits on strategies and funds, carefully reappraising these in the light of overall stockmarket liquidity.
Unfortunately, commercial and regulatory pressures have encouraged an increase in fund scale. To this is added the social proof of feeling more comfortable alongside others who have backed the same manager. This is a network effect, reducing marketing costs if distributors and the press are unanimous in their endorsement of a “guru”. Despite the academic evidence that very long periods are needed to demonstrate investment skill, track records of three or five years are often used for this endorsement. And, where longer term records are cited, these are often disjointed with few questioning the data.
Many years ago, regulation outlawed commission structures that incentivised volume sales targets. Rightly, it was recognised that this posed a conflict with best advice. Now, the downward pressure on fees appears to be at risk of delivering similar conflicts. It sounds good to cut fees for platform costs for bigger funds, but this brings other parties into the same conflict between liquidity and fund size. Even without a direct volume incentivisation, a discussion along the lines of “if the management fee was even lower, we could sell much more and everyone’s total revenues would be higher” achieves much the same result.
Since the gating of property funds in 2016, in the aftermath of the Brexit referendum, regulators have searched for better rules. The arrival of independent directors on fund boards later this year may help. But, there may need to be separate approaches for institutional investors and private clients in a fund, use of tenders as a gate is removed, and external supervision by a valuation specialist of the restructuring process during a fund closure.
Underlying today’s problems are some unhelpful forces. Fund scale is now driven as much by cost issues as performance. In the stockmarket, liquidity and pricing are closely linked; the right price to sell a large position may be a much lower price than mid-market. And, overall the focus on cost has side-lined risk management, stewardship and long term performance. A new approach should recognise all these factors.