Following the illiquidity issues that hit UK Property Funds after the Referendum vote on 23rd June, we wondered if other sectors could be hit by the same issues and found that UK Smaller Company Funds could be the next sector to leave UK investors with frozen investments.
SCM Direct were one of the first to highlight the liquidity issues connected to property funds to the UK regulator, the FCA.
The issue was a fundamental liquidity mismatch where investors were being allowed to buy or sell these funds daily, whilst the underlying investments would take months to buy or sell. As at the end of September 2016, a full 3 months after the Brexit vote, there is still £9 Bn of investors’ money suspended in property funds, with M&G and Standard Life likely to re-open their funds at the end of 2016 and Aviva even later. But the problem does not stop there. When funds in a portfolio are suspended, it can lead to the whole of an investor’s portfolio being suspended – for example, in August Standard Life called a halt to any investors wanting to cash in its life insurance bonds following the property fund suspension saga.
Financial Advisers Too Simplistic When Assessing Fund Risk
As many investors still use financial advisers (IFAs), clients naturally rely on these advisers to advise on investment risk. However, IFAs tend to be ‘obsessed’ by simply how much a fund changes in price each day (volatility risk), whist ignoring liquidity risk – that is, how long it might take to sell the actual investments in a market panic situation.
When lots of investors withdraw, a fund’s cash level is depleted. To cope with further outflows, funds need to begin selling the assets within the fund, which can take time. Until they do this they will not have enough cash to return to investors, thus become illiquid.
We were interested to see if the same would occur in other fund sectors and found that the UK Smaller Companies sector faces similar liquidity risk issues if there was a run on these funds in the face of investor nervousness.
Our analysis looked at the following sectors – UK All Companies, UK Equity Income, UK Smaller Companies, Global Emerging Markets, European Companies Excluding UK, European Companies Including UK and European Smaller Companies sectors.
Once we applied our full screening criteria, the research segment of 187 retail funds from all the sectors listed above, with assets invested amounting to £245 billion, were analysed to see how many days, and at what cost, would investors be facing if they experienced either a 10% or 20% redemption. (Data via Bloomberg on 19th & 20th September 2016.)
Findings
The average UK Smaller Companies fund has investments which would take more than a day to sell if 10% or more of the fund was redeemed. Yet these funds allow investors to buy and sell the fund daily when the funds itself could potentially not meet such redemptions if just 10% of investors redeemed.
We were extremely concerned to discover that 73% of the UK Smaller Company funds had a liquidity mismatch between their underlying holdings and the daily liquidity offered to investors should 20% of their funds be redeemed.
Several large funds, with £4.6 Bn in total invested, were found to take two weeks or more to meet a 20% redemption, based on the funds participating in 10% of the daily volumes in the stocks held
But – what if it was more than 20%?
Our research found one fund where it would take 53 business days to sell to sell 50% of the fund. If it had to sell the entire fund, it would take 22,706 business days i.e. 89 years. Even if the fund managed to participate in as much as 30% of daily volumes, it would still take 7,569 business days i.e. 30 years to liquidate the whole fund.
Of course, in such circumstances a manager might try and place large holdings in the market rather than sell small amounts each day but this might lead to pricing issues as the first investors ‘out of the door’ would receive a far higher price than ones who redeem later. In such a scenario, it might require the fund to suspend dealings completely to ensure all investors are treated fairly but that means their money would be frozen.
In light of our research, I would encourage all investors in the UK Smaller Companies sector to speak to their adviser or fund group and ask them to look beyond simply how much a share price moves up or down each day, in terms of assessing fund risk. In the wider political landscape we find ourselves, illiquid investments may prove to be a much higher risk.
Gina Miller
Founding Partner – SCM Direct
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