HOW LOW CAN YOU GO?
Financial markets may be soaring but for some the equity funds bubble has burst, leaving investors trapped in funds, helplessly watching their value plummet to new lows, says Bill Jamieson
Investors beware the pitfalls of liquidity traps
Money, money everywhere – but the nightmare for UK investors this year has been falling into a liquidity trap: funds where there is not enough ready cash to meet demand for withdrawals.
The most dramatic example is the crisis that has befallen former star manager Neil Woodford. Avidly followed by thousands of small investors, his huge Woodford Equity Income fund, one of the largest in the market, was forced to suspend dealings this summer.
His is by no means the only fund to suffer. Other equity funds have also found themselves under pressure. And many open-ended unit trusts specialising in commercial property have been caught out, sparking a blazing row over regulation.
Outgoing Bank of England Governor Mark Carney declared in June that funds holding illiquid assets were ‘built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid. And that leads to an expectation of individuals that it’s not that different to having money in a bank’.
So how could this crisis have developed? Financial markets are awash with cash. Monetary easing by central banks have flooded the system with liquidity.
Instead of languishing after the 2008-09 financial crisis, asset prices – shares in particular – were driven to new highs. Ultra-low interest rates have encouraged households and companies alike to borrow record sums. Accounts of companies brought down by over-borrowing are now rife.
Yet today the talk is not only of already ultra-low interest rates being pushed even lower but also that interest rates on long-term bonds have gone negative: you have to pay for the privilege of saving.
What a paradox. How, amid all this, could there be a liquidity crisis facing investors? For years Neil Woodford was seen as the man with the Midas touch. When he headed investment giant Invesco, investors flocked to him. When he left to set up on his own, hundreds of thousands of investors followed, fired by glowing reviews from analysts, financial advisers and brokerages like Hargreaves Lansdown.
The launch of Woodford Equity Income was a success. But this was a crowded market, with hundreds of competing income funds and trusts. Shares offering higher than average dividends looked toppy.
If Woodford’s new fund was to maintain a competitive edge, it needed to seek out undiscovered but promising smaller companies whose success over time would boost performance. So he set about building a portfolio that could offer private investors a combination of big blue-chip, higher than average dividend payers and the prospect of capital gains through holdings in undervalued minnows.
Woodford took these holdings in small, fledgling stocks and unquoteds close to the 10% limit allowed for a unit trust. Indeed, he was able to hold around double this amount by listing some of his stakes in those stocks on Guernsey’s stock exchange – where they were rarely, if ever, traded.
But performance did not follow. The UK market was hit by concerns over Brexit, business investment and confidence suffered and many international investors began to steer clear of the UK. Particularly out of favour were smaller, domestic-market facing UK companies, considered more vulnerable and without the reserves and resilience of the mega-caps.
Investors began to pull their money out. But the fund’s holdings in small companies and unquoteds proved difficult to sell without driving their share prices down further.
So holdings in larger companies were trimmed. But as he did so, the maximum percentage allowed for investment in unquoteds threatened to breach the 10% ceiling. Woodford, caught in this trap, moved to suspend dealings.
It was hoped suspension would be temporary. But more than 500,000 investors in the fund have been locked in since June, condemned to watch helplessly as the unit price continued to fall.
Investors have now suffered a near 20% fall since dealings were suspended in June when Kent County Council attempted to redeem a then-£250 million investment in the fund. Fund assets, which stood at £3.7 billion at the time, have now plunged below £3 billion. This was the worst performance of any of the 2,760 funds based in the UK over that four-month period. By contrast, the FTSE All-Share was up 1.8%.
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Investor demand for withdrawal found funds with dangerously low levels of cash to meet redemptions
Suspension was scheduled to end in December. But such is the scale of the feared rush to the exits that there is talk this may not now be lifted until next year.
Similar problems have also beset other funds in the Woodford Investment Management stable such as the Patient Capital Investment Trust. Due to large cross-holdings, it has now set up a contingency plan to replace Woodford if its fund manager’s business collapses from the crisis engulfing the Equity Income fund. PCT suffered a 26% first-half drop in net asset value due to the fund’s forced sales and write-downs.
Other unit trust funds, particularly those specialising in property investment, have also suffered. Commercial property holdings can’t be as readily realised as shares in a company.
As concerns mounted over the outlook for the sector, prompted by a slowing economy, low business investment and the crisis that has engulfed the high street retail property market, a similar investor demand for withdrawal found funds with dangerously low levels of cash to meet redemptions.
A row has broken out over moves by the regulator, the FCA, to tighten the rules of the funds’ management. It has proposed a new rule requiring property funds to suspend dealing if there is ‘material uncertainty’ over the value of 20% of their assets.
‘Too restrictive’, say the unit trust fund operators, who fear it will likely lead to property fund suspensions, ‘potentially increasing systemic risks and driving investors out of open-ended funds’. The FCA is also considering imposing changes to the rules governing how funds invest in unquoted and hard-toptrade stocks in the wake of the Woodford debacle.
‘Too little, too late’, say rivals in the investment trust sector whose share structure means that managers do not have to sell holdings to meet withdrawals.
The Association of Investment Companies has accused the regulator of a lack of urgency in its response to the problem. It says the FCA should have gone further to restrict openended funds’ forays into less-liquid investments.
Thus the paradox: a liquidity trap for investors amid falling interest rates, more quantitative easing and an explosion of mega debt, here and in the US. But government spending is set to let rip. The IFS warns the UK budget deficit could soar back up to £100 billion or 90% of GDP.
While fixed interest rates remain ultra-low, investors are not only driven to stay in the stock market, but also to seek out alternative assets in the search for returns. If it all looks like a bubble, and trembles like a bubble, the chances are – it probably is.