Open-ended funds: beyond redemption?
24th June, 2019
Open-ended funds aim to hold enough cash in reserve to allow the manager to meet redemptions without having to sell holdings. Problems can arise, however, when the manager is faced with an unexpectedly large redemption, which could force the sale of securities.
• Market instability creates a challenge for managers who need to sell holdings
• Sometimes funds are suspended to allow the manager to reposition the portfolio
• The FCA is finalising new rules to strengthen liquidity management
Of course, human nature means that investors are more likely to want to sell their holdings when the market is performing poorly – and this is often a particularly bad moment to sell.
During periods of significant market instability, managers in open-ended funds will find it harder to get rid of their underperforming or illiquid assets, and will, therefore, find themselves forced to sell their higher-quality or more liquid securities. A raft of withdrawals makes it even harder to manage a fund’s liquidity; typically, the investments that can be sold most quickly tend to be larger, more liquid securities. In some rare cases, the fund might be suspended in order to allow the manager to reposition the portfolio whilst protecting remaining investors’ interests.
The Investment Association (IA) believes that investment managers need to ensure that they “not only get a fair price for the client who wants to exit but also protect the value of the holdings for those who remain”, and therefore industry regulation allows the suspension of funds to protect investors, “whether they want to exit the fund or stay in it”.
The Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey, believes that fund suspensions, although rare, “should be available and used when it is in the best interests of investors and the integrity and stability of financial markets”. The FCA is finalising new rules on funds that invest in property and other illiquid assets in order to strengthen liquidity management.
A paper published by the FCA discussed the benefits for open-ended funds with investments in relatively illiquid assets to be able to change their pricing methodology during periods of market instability in order to avoid the risk of fire sales. The FCA examined the advantages of alternative pricing rules – “swing” or “dual” pricing – that is designed to adjust funds’ NAV in order to pass on the costs resulting from the redemption activity to the shareholders involved. This process helps to protect the interests of long-term investors, whilst removing the “first-mover advantage” that stokes the incentive for a run on a fund.
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