U.K. Fund Freeze Should Send A Chill Down Your Spine

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Includes: FCNTX, TFCVX, VDC
by: Reuben Gregg Brewer

Summary

The Brexit event led to U.K. property funds suspending shareholder redemptions.

That's exactly the type of thing that leads to a “run on the bank” type event.

Don't think it couldn't happen in the United States, too.

When the United Kingdom voted itself off the European Union island it set the stage for a volatile period in global geopolitics and potentially troubling economic times. We are a long way from seeing the end of this story and the drama has already been pretty intense. One of the most frightening consequences for investors was the raft of U.K. property fund closures that swiftly came about after the so-called Brexit vote. If you think something similar couldn't happen in the United States, think again.

Long investment, short investment
From a big-picture perspective, the problem with the U.K. property funds is pretty simple. These funds, much like U.S. pooled investments, were gathering assets from multiple investors with, in this case, the intent of buying property. There's nothing inherently wrong with that plan. The funds get cash, they buy properties, and they use the rents to pay dividends and meet any redemption requests with new cash inflows or cash on hand. As long as the number of investors asking for their money back is a small percentage of the whole, there's no problem.

The risk here is that property is a long-term investment that is, generally speaking, fairly illiquid in nature. In other words, you can't just run out and sell a building to quickly raise cash if you get an influx of redemption requests. If you try, you're going to have to take a fire-sale price that will hurt the remaining investors and the fund's overall performance. Luckily such redemption spikes are pretty uncommon, unless, one day, the U.K. decides it wants to leave the European Union.

With long-term illiquid investments in the portfolio and the short-term nature of the cash these funds get from shareholders, the funds were left with little choice but to stop honoring withdrawal requests. Simply put they didn't have the money. This is a classic bank run type event that spiraled from one fund to others as investors realized that their fund might be next. It appears that the damage has been contained and that these property funds are the only ones that have had this problem.

The SEC is right to worry
Something like this couldn't possibly happen in the U.S. market, except that it already has. Third Avenue Focused Credit Fund (MUTF:TFCVX), facing large withdrawals and holding a significant amount of illiquid, and high risk, bonds, stopped its shareholders from pulling their cash out in late 2015. Stone Lion Capital, a hedge fund shop, did a similar thing in the same bond space. They couldn't sell the bonds in an orderly way and, thus, closed their doors.

In other words, what's going on at these U.K. property funds has already taken place in the U.S. market. Only in the case of Third Avenue and Lion Capital the problem wasn't precipitated by a larger market event, like the Brexit vote. So the issue appears to be pretty minor. That, however, hasn't stopped the Securities and Exchange Commission from sounding the warning alarm... and perhaps rightly so.

In most cases liquidity isn't that big a deal for a mutual fund or exchange traded fund. The prices a pooled investment product gets for its assets may not be what it wants, but selling liquid investments can get done pretty quickly. The problem comes in when the assets aren't liquid. Like buildings or thinly traded bonds, in the case of Third Avenue.

But wait, you have to include private companies in that mix, too, since well-known mutual funds like Fidelity Contrafund (MUTF:FCNTX) are increasingly investing in such things. And then note that exchange traded funds are getting more and more esoteric, investing in increasingly obscure niches - slice and dice fine enough and a sector decline could turn into a sector rout if enough investors try to get out at the same time. Even broad based exchange traded funds, like Vanguard Consumer Staples ETF (NYSEARCA:VDC), got caught up in a so-called flash crash in the middle of last year that led to trading halts at the exchange level. Although fund sponsors are working on the issues involved there, there's no reason to believe it couldn't happen again at some point.

A risk to remember
If you have watched what's going on it the U.K. with an arm's length perspective because it's across the pond, you may want to think more deeply about what's happening in their financial markets. There will be an impact around the world and, frankly, the property fund closures are just another example of the type of dislocations that have already been taking place in the U.S. market. Only, in the U.S. the problems investors have faced haven't been driven by a large scale event and have appeared to be unique in nature - until you start putting the dots together to see a bigger picture.

Indeed, there is a real risk that you, too, could be locked off from your money if you don't take the time to understand what you own. And even if you do understand that you are investing in something that has liquidity risk, you may be underestimating the intensity of the emotional response to a bank run type event. It's a real risk and it's worth thinking about it now before you are faced with it in real time. The U.K. property fund closures are a warning sign that's worth paying attention to. And maybe you might want to heed that old rule of thumb and keep three to six months worth of living expenses in easy to get at cash, too. You know, just in case...

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.