The City watchdog and Bank of England are poised to step in soon to tighten up rules for open-ended funds investing in illiquid assets after a surge in investor withdrawals led to the suspension of two property funds and sparked concern about a domino-effect hitting similar funds and anger about insufficient regulatory action.
Last week, M&G PLC (LON:MNG) temporarily suspended dealing in its open-ended M&G Property Portfolio Fund and feeder fund, and late on Friday M&G’s former parent Prudential PLC (LON:PRU) suspended its £164mln UK Property Fund.
In total, there is around £15bn of investor money tied up in various UK direct property funds.
After calls from the public and industry grew louder, the Financial Conduct Authority said in the summer that it was taking a closer look at the issues around illiquid investments.
A spokesperson for the City watchdog said over the weekend that the FCA was “working with the Bank of England to review how funds redemption terms might be better aligned with the liquidity of their assets”.
Shockwaves through the sector
“This suspension could send shockwaves through the sector and have a domino effect on the remainder of the funds,” said Adrian Lowcock at investment platform Willis Owen.
While only one group is so far affected, he added: “This is a sector which cannot cope with large withdrawals in a short space of time, and contagion risk is very real.”
Other asset managers reported some redemptions from their funds, with Columbia Threadneedle saying it had seen £56.6mln of net redemptions from its UK Property Fund, but said its cash position had improved after selling off several assets. Standard Life‘s Aberdeen UK Property saw outflows of £31.6mln on Wednesday alone last week, according to Morningstar data.
M&G, which has seen its property fund shrink by £1.1bn so far this year, blamed “continued Brexit-related uncertainty and ongoing structural shifts in the UK retail sector” in recent months, which had led to unusually high outflows by retail investors.
The situation is reminiscent of 2016, when a run on direct property funds followed quickly after the Brexit referendum, with Aviva and Standard Life both suspending redemptions.
Issues around open-ended funds investing in illiquid assets, such as property and unlisted companies, is especially sensitive this year, with thousands of small investors sitting on sizeable losses after the collapse of former-star manager Neil Woodford’s empire.
An increasing swell of redemptions from his flagship Woodford Equity Income fund led to it being gated as he was unable to stump up the cash because so many of his investments were in illiquid small-cap assets.
These funds, also known as unit trusts, are able to hold up to 10% of their assets in unquoted stocks, while funds that are wholly focused on less liquid assets such property, private equity and debt will obviously have most of the fund assets tied up.
This can lead to liquidity issues for the fund managers if there is rush of investor redemptions, as the open-ended fund structure means they need to give the cash back immediately to departing investors and, if there isn’t any, they need sell some investments to generate the money.
In June, the Investment Association revealed plans for a new asset class that is aimed at addressing such liquidity issues.
In September the FCA introduced a new category of ‘funds investing in inherently illiquid assets’, where such funds will be required to be open about how liquidity is managed, give risk warnings in their promotions and produce liquidity risk contingency plans.
These proposals could be brought forward to before Christmas, newspaper reports suggested, as they could pose a risk to the wider financial system.
“We’ve been frustrated it has taken a long time for the FCA to act on this,” said Annabel Brodie-Smith of the Association of Investment Companies, which represents the closed-ended fund sector, which many experts say is a more appropriate structure for less liquid investments.
“We’ve seen from the suspension of Woodford Equity Income that locking investors out of their cash has harmful consequences not just for those investors, but for the reputation of the entire industry.
“While there are clearly differences between the Woodford suspension and the suspension of M&G Property Portfolio, the key similarity is that both involve assets that are hard to sell being held in a daily-dealing, open-ended structure.
“This gives an illusion of liquidity that unfortunately can evaporate when investors need it most. So unless we sort these problems out, we could have a real job on our hands persuading the general public to put their trust in the investment industry.”
Most financial advisers only use open-ended funds, said Brodie-Smith, as they are familiar with this structure and often don’t feel they have the knowledge or confidence to recommend closed-ended vehicles such as investment companies.
While there has been some movement by financial advisers using property investment companies, such as REITs, she said it takes time to change ingrained habits.
“For property, we strongly believe that the closed-ended investment company structure is the better option because investors can always sell their shares, while the manager doesn’t have to sell properties as a result and can invest with a long-term view.”