The gating of Neil Woodford’s flagship LF Woodford Equity Income fund has put plenty of attention on the issue of fund liquidity but the industry needs to make sure that the correct lessons are learnt, according to SVM Asset Management’s Colin McLean. 
Last week saw LF Woodford Equity Income suspend redemptions, sales and transfers in its units after an extended period of underperformance led to sustained outflows and problems selling out of its illiquid unquoted holdings.
The unexpected gating of this high-profile fund means that liquidity risk is at the forefront of both advisers’ and clients’ minds but SVM managing director and chief investment officer McLean argued that the debate around it needs to be wide-ranging and cover more than just the basic issue of whether open-ended funds should be allowed to hold illiquid assets.
“There is a danger that the wrong lessons will be drawn from recent events,” he said.
“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?”
While much of the debate at present has centred on small or unquoted companies, McLean pointed out that “big percentage holdings matter whatever the company size” when it comes to liquidity risk and the debate has to acknowledge this.
This means that all fund groups should be able to demonstrate to their investors that they have sufficient processes to monitor liquidity and that information is readily accessible to the portfolio managers responsible and to independent governance.
While intervention in a fund can come from those with regulatory responsibility, those with independent governance duties can also step in but it must be kept in mind that all parties could experience “emotional conflicts” if issues arise.
“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, McLean said.
“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.”
What’s more, he believes it is important that liquidity monitoring should be firm-wide, rather than on a fund-by-fund basis. The trend for harmonisation of portfolios within the same investment firm means that stock concentration has been encouraged, which may contribute to liquidity risk.
“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,” he said.
The SVM managing director also noted that the timescales, vehicles, client expectations and communications around an open-ended fund are all different from listed investments, making it challenging to hold unquoted stocks.
Added to this is the “inherent conflict” present in an open-ended funds, whereby the managers needs to have confidence in its holdings’ valuations and liquidity as inflows or outflows are experienced. This conflict can be difficult to manage, McLean said.
“Managers themselves are conflicted in this – putting a lot of responsibility on the ACD, compliance and governance,” he said.
“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.”
But simply deciding to avoid unquoted holdings might not be a solution. Even managers with portfolios built entirely from typically liquid stocks need to have a robust fair value process as issues such as companies being suspended, markets closing for the day or collapsing liquidity requiring a stock price adjustment will be encountered from time to time.
“In practice, few managers and ACDs are structured to provide daily oversight of this process,” McLean added.
Of course, the potential for outperformance from stocks further down the market capitalisation spectrum means that fund managers tend to add less liquid stocks in the pursuit of higher returns.
The SVM managing director conceded that liquidity may well be “reasonable” in these stocks but it will not be as good as FTSE 100 names; meanwhile liquidity can be “patchy” in companies that are continually raising money, which also might have a changing shareholder register and lack of broad analyst coverage.
This bring us to another area that needs to be included in the liquidity debate, according to McLean: the issue of fund size. “All of these suggest that investment firms should set capacity limits on strategies and funds, carefully reappraising these in the light of overall stock market liquidity,” he said.
However, a desire for ever larger funds has followed the increasing commercial and regulatory pressures on asset management houses, while investors suffer from a herding instinct that sees them feel more comfortable in strategies that plenty of others have backed.
“This is a network effect, reducing marketing costs if distributors and the press are unanimous in their endorsement of a ‘guru’,” McLean said.
“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.”
Finally, he argued that the negative effects of lower fees should be part of the conversation around fund liquidity. While it might sound like a good idea to cut fees for platform costs for bigger funds, this may have the effect of channelling more investors into the same portfolios and heightening their liquidity risks.
In light of this, he suggested that a new approach to fund liquidity will have to address a wide range of issues.
“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,” McLean concluded.
“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 stock market, 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.”