Open-ended funds investing in illiquid assets such as physical property and infrastructure could face tough new rules from the financial services regulator, designed to help protect investors in times of market stress.
Restrictions are being consulted on by the Financial Conduct Authority (FCA), which include forcing funds to stop trading, and not allowing investors to withdraw capital, as soon as there is any doubt over the value of underlying assets. This would be based on an independent asset valuer having "material uncertainty" over the value of at least 20 per cent of the fund's holdings, the FCA said.
This would be a shift away from the current situation where ceasing to trade is seen as a last resort. While gating investors' capital is never ideal, it is necessary to make sure funds are not forced to sell assets to meet investor redemption requests when valuations are either uncertain or falling. This results in remaining investors' returns being hampered but only to satisfy those leaving the fund.
The status quo also allows for 'first-mover advantage', meaning those quick to redeem their investments can do so at a higher valuation than is actually the case, hampering investors who redeem later on or stay in the fund.
The new rules would also apply to fund of funds, and property feeder funds that hold more than 20 per cent of their portfolio in funds that have suspended trading.
There could be further positives for investors. The regulator suggested funds would also be discouraged from holding cash buffers. Historically, cash has made up a significant proportion of an open-ended illiquid asset fund, so managers can deal with investor withdrawals without being forced to sell assets. However, this meant has investors paying for funds which are not fully invested, and cash holdings also extenuate the problem of first-mover advantage.
Regulatory changes were expected after the FCA said investors faced unfair treatment under the current system, most notably in the aftermath of the 2016 European Union referendum vote. Several open-ended property funds had to stop trading as investors rushed to withdraw their money, but were criticised for not having an appropriate structure in place to deal with the situation.
The new rules would produce a fairer balance between investors wishing to remain in a fund and those wishing to sell by bringing in greater clarity around suspensions, the FCA said. It would also make ‘fair value adjustments’, also known as ‘market value adjustments’, a thing of the past. This is when asset managers take into account events subsequent to a fund’s trading suspension, and make an estimate of its valuation.
Ryan Hughes, head of active portfolios at AJ Bell, said the proposals mean property funds would suspend trading sooner in times of market stress, and potentially more frequently than previously witnessed.
“This isn’t necessarily a bad thing [as] the rule would make it fairer for investors,” he said. “The FCA is saying funds need to have far a more robust approach to liquidity management, so everyone knows how they will manage in a difficult environment.
"The rule changes make it clear-cut when a fund needs to suspend, which takes away the big problem of none of the funds wanting to be the first to suspend because it looks bad from a marketing perspective. This is not a good method to managing investment."
But Jason Hollands, managing director at Tilney Group, warned the proposals could also lead to multi-asset and fund of funds taking a more conservative approach to owning open-ended property funds, to avoid breaching the 20 per cent threshold.
“I’m not sure there will be appetite to build big positions in listed vehicles instead, so the overall outcome could be less exposure to property,” he said.
The FCA is also proposing that funds investing in illiquid assets develop better contingency plans in event of market stress, and improve communication to investors about their liquidity risks. The consultation is open until 31 January 2019. You can submit your response at: https://www.fca.org.uk/cp18-27-response-form
