A decade ago it was a lack of liquidity that froze the world’s financial system. Last year the liquidity iceberg brought an end to Neil Woodford’s fund management venture and struck the £2.5bn M&G property fund, which was forced to ban withdrawals.
To most investors, “liquidity” comes down to a simple question: “Can I turn this asset into ready cash quickly when I need it, and will I have to suffer a big discount to do so?”
The Woodford crisis arose from the fund’s over-exposure to unlisted stocks that it struggled to sell when investors wanted their money back. The M&G Property Portfolio fund was somewhat different. Investors should be aware that property is illiquid and the 2016 problems with these funds should have been a warning. Nevertheless, the M&G fund is an “open-ended” fund that under normal circumstances allows investors to withdraw money almost instantly.
The worry is that this liquidity threat may be quietly growing.
Lurking liquidity threats
The peer to peer lending market (P2P) is one area of risk. Last year we saw the collapse of Lendy, which lent to property developers. Investors are likely to lose much of their money. Another buy-to-let P2P lender has this month closed its doors to retail investors.
Beyond that there is the danger facing smaller company markets.
The Markets in Financial Instruments Directive (Mifid II), a set of European regulations introduced in 2018, required brokers who execute buy and sell orders on share transactions to separate their charges for trading from those for research. Research acts as a lubricant in the market, giving investors information with which to make buy or sell decisions. Broker businesses often used to offer it for free, cross-subsidising the costs with their brokerage fees.
Mifid II removed the potential for conflict of interest that this created but it appears to have led to a reduction in the amount and quality of research available on small and mid-cap stocks. This has made these stocks less liquid.
This is not just a problem in the Alternative Investment Market (Aim). It also affects the FTSE Small Cap index, where companies are worth around £50m upwards, and the FTSE 250 index, where they range from £250m to nearly £4bn.
New liquidity reporting rules
The FCA has announced new rules, to apply from September, on how sophisticated funds manage liquidity and disclose risks to investors. It is talking to the Bank of England about how to address the problems that occurred with Woodford and the property funds that closed in 2016. It is due to issue a statement soon. Expect more risk warnings. Funds may have to change their redemption terms and are likely to have to rethink how they report their liquidity.
At the moment managers often say they can sell a certain percentage of their assets in a short period. But that is not particularly helpful, as the Woodford problem highlighted. If the only stocks that can be sold are FTSE 100 companies and what is left is a portfolio of small-cap stocks, some of which might take months and deep discounting to dispose of, then the liquidity numbers that prevail in normal times are no guide at all.
All investors must be treated fairly but this can be difficult to achieve when liquidity dries up. Early redeemers arguably get a better price and a quicker result. Those slow off the mark are potentially gated. They may get a much lower price when finally they receive their money.
The regulator is in an unenviable position. There is a danger that in seeking greater fairness it might force funds to close the gates earlier than they would have done previously. This could trigger more investors to place redemption requests and worsen the liquidity problem.
Implications for investors
What does this mean for investors? There can be high rewards for shrewd individuals who have the research expertise and the capacity to bear some illiquidity – they should enjoy a premium for their faith in less liquid assets. But a vital question naturally arises for those investors without such capacity: why take the risk of the illiquidity that investing in smaller companies can bring?
This will drive more investors (and fund managers) into large-cap stocks. It could make multi-cap funds – those that invest in a blend of small and large companies – less attractive. This is because, as Woodford investors found, investors could be locked in if the fund has to close.
Investors may be wise to understand who they are investing alongside, too. Certainly, good wealth managers investing in funds will consider the risks of one institution that owns a large proportion of the assets requesting an early redemption (as Kent County Council did for Woodford).
Another impact is that the stock market’s prices for small cap companies are no longer higher than the prices being offered by private equity investors. Why subject your business to the scrutiny and cost of the public markets when private equity offers the same value?
Helping the markets
The government is currently exploring ways to encourage high-growth companies to float in London after Brexit. It needs to. Four years ago there were 1,044 Aim companies. At the end of 2019 there were 863 — a fall of more than 17 per cent. That trend looks set to continue.
It is not healthy. It denies everyday investors the chance to back Britain’s most promising companies and forces a wave of money towards the FTSE 100 giants, driving those share prices higher than is necessarily justified.
We need to consider how to protect investors from liquidity risk. That also means thinking about how to make our listed markets more liquid.
By Jamie Hambro
Posted on 16th January 2020
This article first appeared in the Financial Times
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