The essential idea of an open ended fund is great. People can add new capital in, the funds goes and buys more stuff. They want cash out the fund sells something and gives it back. Why not? Well, the problem is the basic structural one of liquidity. This makes open ended funds, in times of market turbulence, dangerous for investors. This is what has just happened to the Woodford Equity Income (CFWEIAA:LN) fund in the UK.
So, the investments are in something or other. How fast the fund can pay back investors if they want out is determined by how quickly they can sell those investments. And what if people want out faster than the funds can be liquidated? Then redemptions from the fund have to be suspended. Which is exactly what has just happened.
We all know about fractional reserve banking. The bank doesn't have our deposits down in the basement, they're out in the loans and mortgages. If we all turn up and demand our money back today then the bank doesn't have it - we get a bank run. There we've a central bank willing to supply the missing liquidity. Funds don't have that as LTCM showed those years ago.
The underlying reality here being that whatever the promises of liquidity - ease of getting out of the fund - promised by the promoters, in the end they can only be as liquid as the market in which they're investing.
An open ended fund in Treasuries is just fine. Sure, it's possible to think of circumstances in which the Treasuries market freezes up and a fund can't liquidate positions. But such circumstances are so extreme that we'll all have other things to worry about - stocking the basement with beans and buckshot - than how we can get out of our investment position.
There have been, in London, a number of commercial property funds that were set up as being open ended. That was always a bit of a worry given that a commercial property deal can take months to put together but they were promising funds back to investors in days. When push came to shove there was a run on several of them and they did close to redemptions.
Fitch warned us back here about the dangers of corporate bond funds run on this basis:
Open-ended bond funds provide daily liquidity for investors but are increasingly investing in longer-dated or lower-quality securities as bank regulation has reduced the supply of market liquidity and investors are seeking extra yield while interest rates remain low. This exposes funds to liquidity pressure if there is a spike in redemptions, potentially leading to forced asset sales and a run on the fund as investors pull out. The risks are most pronounced in purely credit-focused funds with less-liquid underlying assets, such as corporate loans and bonds. We estimate pure credit funds are about 15% of total global bond funds.
Most corporate bond issues are decidedly illiquid, meaning there's a considerable mismatch between the liquidity in the underlying and that promised to investors.
Equities are normally more liquid than corporate bonds and less so than Treasuries. So, we would imagine that an equity fund would be less likely to face this sort of problem. Well, yes, but that depends upon the strategy that the fund is following.
Something that is holding the DJ 30, or the S&P 500, the underlying stocks there are pretty liquid. And such a fund is unlikely to be holding anything more than single percentage points - if that - of the particular stock in question. We're liquid in the underlying in the sense that a few phone calls can shift such stakes. Maybe not at the very finest prices, but it can be done. The liquidity mismatch isn't really there.
Now look at what Woodford's fund was doing. He's known as the best stock picker in London - none of this shadowing the indices for him. Thus he's building up significant stakes in not entirely and wholly first line stocks:
Its problems were exacerbated because a significant proportion of its investments were in illiquid shares, which are difficult to sell at short notice, Mr. Hughes said. “This is not a decision that will have been taken lightly and it is done to protect the interests of remaining investors,” he added.
A string of investment positions have gone wrong for Mr. Woodford, including large stakes in Provident Financial, the high-cost credit business, Allied Minds, the technology investor, the AA and Purplebricks, the online estate agency. Meanwhile, his once huge holdings in easily sellable companies such as Astrazeneca, Legal & General and Lloyds Banking Group have mostly been offloaded to fund redemption requests.
The fund has already been selling its liquid stocks to fund redemptions. What's left are substantial - so, significant portions of outstanding equity - slices of companies where selling even 1% of the company would be difficult, plus private market investments which are, by definition, less than liquid.
That this is all a bit new and surprising can be seen in the coverage. Today's Times has no fewer than five pieces on the subject. But the underlying possibility has always been there given the mismatch in liquidity on either side of the fund.
What can be done is the fund can dump - try to dump - its positions at fire sale prices. Or it can simply not allow redemptions. That second is legal but not wholly helpful - it also means stopping the transfer of any holdings, even private sales are not allowed.
But this is our basic problem when we do have such liquidity mismatches. Maybe, at some point, those promises will be put to the test. At which point those promises won't hold up.
Essentially, be aware of this problem. Sure, most open ended funds, invested in whatever and however illiquid, won't come up against this problem. But any that do will have only one of those two choices. Dump positions to fund redemptions, in which case we lose part of our investment. Or suspend redemptions in which case we're losing the very thing we went into such a fund for, liquidity.
An open ended VC in early stage companies fund would be ludicrous - which is why they're all close ended and insist on 5 year redemption periods. An open ended Treasuries fund is just fine - we've all got larger problems if those markets freeze over. Somewhere in between is the line and strategic positions in second line equities seems to be the wrong side of it as might be corporate bonds and commercial real estate.
Our lesson then is that when considering a fund we need to look at the liquidity on offer to us as investors and that in the underlying market. If what is being promised can't be achieved in the underlying then we're leaving ourselves open to this sort of either fire sale valuation of suspension of redeemability.
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