The subject of liquidity in investment funds has been firmly in the spotlight over the past month following the suspension of dealing in the LF Woodford Equity Income Fund and heavy outflows at H2O Asset Management after Morningstar had downgraded their Allegro Fund expressing concern about the “liquidity and appropriateness” of some corporate bond holdings. Interestingly H2O responded saying that “liquidity is not an issue”. In contrast to Woodford, H2O did not suspend dealings in the fund’s units and suffered reported outflows of some $7bn over the following few days.
Woodford’s fund, launched with much fanfare when he set up his own firm a few years ago, has suffered from very poor performance and had more then halved in size from its peak of over £10bn in early 2017. This steady outflow increasingly put pressure on his ability to manage the fund’s exposure to illiquid and unquoted stocks while staying within the UCITS rules. In March it came to light that in order to stay within those rules, Woodford had re-structured and listed some of these unquoted holdings on The International Stock Exchange in Guernsey (TISE). While this meant they could be considered as “quoted” shares, TISE is hardly a cauldron of trading activity. Rather, it is more normally used to list funds and special purpose vehicles or complex products, so that they can be priced. In other words, the liquidity of these holdings didn’t improve. Once the fact that the fund was struggling to meet its regulatory requirements had become public, the rate of outflows accelerated and within a few weeks, Woodford and the fund’s Administrator, Link decided that it would be better to protect the interests of continuing investors by suspending dealings in the fund.
Given the scale and profile of Woodford’s fund, the suspension of dealings has attracted huge attention. Andrew Bailey, Chief Executive of the FCA (and hitherto one of the favoured candidates to become the next Governor of the Bank of England) was grilled by members of the Treasury Select Committee. Chair of the Committee, Nicky Morgan MP, asked whether anyone at the FCA actually reads the newspapers and follows what is going on in the industry. Meanwhile, the current Governor of the Bank of England, somewhat unhelpfully, perhaps, stated that funds which offered daily liquidity while investing in part at least in illiquid assets are “built on a lie”. Of course, its all a matter of degree. A bank is built on the premise that its depositors won’t all want their money back at the same time, thereby enabling it to lend to borrowers over much longer periods. Money market funds are exactly the same.
The question is, should equity or bond funds engage in such liquidity arbitrage and, if so, to what extent? And whose responsibility is it to oversee the process and ensure the interests of unit holders are protected? Principally, it is the manager himself who should, but star managers have on a number of previous occasions ignored that responsibility in pursuit of performance and the rewards that brings them. UCITS funds have the additional safeguard that there is both an Administrator and a Custodian whose roles include the responsibility to ensure that what the manager does is not detrimental to investors. Unfortunately, the funds industry is notoriously poor at its own governance. Perhaps, rather than focus on whether the suspension of dealings we should spend time considering an approach where regulators, custodians, administrators and some form of independent investment directors are structured to ensure that what the manager is doing is appropriate from an investment standpoint but not to the extent that it puts investors at risk.