Open Ended Funds and Illiquid Assets...

There's never a simple answer to a complex question.

Our recent posts on Woodford illustrated some of the fundamental problems when an open ended fund (in this case with daily liquidity) nonetheless buys illiquid, micro cap and private securities. But what about other areas of potential liquidity mismatch - such as real estate, alternative credit and insurance linked securities ("ILS").

Taking real estate first, a great post in Citywire asks if the FCA, the UK regulator, should act on open ended property funds.

Per the author:

The saga engulfing the Woodford Equity Income fund, which left clients overexposed to small, illiquid companies, has dominated recent media attention. However, the problem of illiquid assets in UK open-ended funds runs far deeper than a few funds running risky strategies. In fact, it is hiding in plain sight within the widely popular UK direct property fund sector.

Lock-ups of daily-dealing open-ended funds investing directly in real estate - occurring in 2008, again in 2016 and still more in 2019 - have exposed the inherent design flaw of relying on cash buffers to provide liquidity in times of market stress.

Liquidity is rarely an issue when times are good and the supply of capital is strong. But when there is a rush to exit, the liquid reserves built into direct property funds can quickly evaporate. This can force fund managers to close the gates on redemptions, giving them time to raise cash by selling properties, often in a deeply unfavourable market.

Indeed - let's read that again: liquidity is rarely an issue when times are good and the supply of capital is strong.

Elsewhere in the industry, alternative credit and ILS funds typically do not offer retail investors daily liquidity access in a mutual fund format. But they do offer institutional investors open ended hedge fund access to illiquid assets which are primarily (or exclusively) Level 3. They also typically offer the investment manager the opportunity to crystallize an annual (or more frequent) incentive fee on unrealized, paper profits - which is the key difference, aside from liquidity, between a typical open ended and closed ended fund.

(We agree that, for example, ILS financial statements can include imaginative presentations such as "advances under swap contracts", "fixed maturity investments" and "investments under fair value measurement" to escape the Level 3 column. In reality, though, these are all Level 3 assets - private contracts, with no evident secondary trading, subject to pricing estimates in the absence of an actively traded, observable market).

Offering the opportunity for investors to have some liquidity options around "private" strategies obviously has benefits. However, there is also the risk that investors may ignore the liquidity mismatch - and learn the hard way in a period of market dislocation. In fact, we are probably overdue for one of those 7 sigma market events which seem to occur, not every 200 million years, but every 10 or so.