As any financial dictionary will tell you, liquidity describes how easily an asset can be converted into cash. In markets, liquidity is everything. If buyers and sellers can be matched it makes for efficient price discovery, without which we don’t really know how much the assets we are holding are worth – if buyers can’t be readily found, we may have to accept a much lower cash price than we may have expected. As our regular contributor Michael Taylor has previously discussed, this is particularly problematic for those trading shares in smaller companies, which are often far more thinly traded than those of, say, the FTSE 100. Aim investors trying to sell a share after a horrible profit warning will know this only too well.
In the case of Woodford’s funds, the problems also arose because too many investors demanded their money back simultaneously, which meant the fund could not sell holdings fast enough to pay investors back to the point that redemptions had to be halted entirely. It was somewhat reminiscent of the so-called liquidity mismatch we saw in the wake of the Brexit vote, when several open-ended commercial property funds were temporarily ‘gated’ so that investors could not withdraw their cash.
With a twist, though. Property is well understood to be an illiquid asset class – property transactions generally take a long time, certainly when compared to selling equities and especially when real estate markets are weak or there is, as happened after the unexpected referendum result, a sudden fear that they could substantially weaken. Yet before Woodford, the importance of liquidity in open-ended equity funds had apparently been largely overlooked, surprising given the increasing tilt of many into illiquid unquoted investments.
The Financial Conduct Authority is now introducing new rules to provide further protection to investors in funds containing illiquid property assets, but there are concerns that these do not go far enough and that further liquidity crises could in fact be lurking elsewhere in the equity fund industry. Of course, investors in investment trusts – the subject of this week’s special issue – do not suffer such worries; those wishing to cash out simply sell their shares, which makes them a much safer vehicle for illiquid investments. True, the liquidity risk is transferred to the share price and discounts can widen sharply, but while operators of open-ended funds can lock the gate when they need to, at least investment trust owners always have the key to their own cash.
