The Financial Conduct Authority (FCA) has ruled out stopping open-ended funds from investing into illiquid assets completely, as it continues to assess the best way of protecting investors against liquidity mismatches.
Daily dealing funds investing into assets that cannot be easily sold has led to the high-profile gatings of the LF Woodford Equity Income fund as well as a swathe of property funds on a number of occasions, including in earlier this week amid the coronavirus market sell-off.
The liquidity crisis at Woodford Investment Management led then-Governor of the Bank of England Mark Carney to claim these funds were "built on a lie".
The City regulator reiterated its view that the temporary suspension of open-ended funds "can serve investors' best interests in difficult market conditions". However, it admitted the episodes "have raised legitimate questions about the wisdom and appropriateness of promising daily liquidity to investors when funds invest in illiquid or less liquid assets".
In a speech to Investment Association (IA) members, the FCA's director of markets and wholesale products Edwin Schooling Latter said the mismatch between redemption terms can be addressed two ways, "either through the asset side of the balance sheet, or through managing liabilities in a way that better matches asset liquidity".
"We already have rules and guidance that speak to liquidity risks arising from mismatches, though recent experiences do raise the question of whether they need to be tighter," Schooling Latter said.
The director said it was unlikely to act through the former way, which would mean restricting the assets in which daily-dealing funds could invest. Doing that, he said, would mean they could only invest, for example, in highly liquid shares or the highest quality liquid bonds.
Schooling Latter noted UCITS funds limit the amount of assets open-ended funds can invest into assets not listed on a regulated exchange to 10% of a portfolio. Some commentators have noted this allows funds, like Woodford's, to "game the regulations", as there are some highly illiquid stocks trading on exchanges.
Schooling Latter said the FCA would look to review this rule, as it "creates a presumption that listing on an exchange means an asset is sufficiently liquid to meet short-notice redemption requests".
However, he said investors should still be able to access the premium return profile illiquid assets offer through these types of funds. "Overall, we think that imposing additional restrictions on investment in illiquid assets is unlikely to be the best solution for fund investors or the wider economy," Schooling Latter said.
Swing pricing and notice periods
As a result, the speech focused on solutions based around managing liabilities to match the liquidity of assets, highlighting ‘swing pricing' and ‘notice periods'.
Schooling Latter pointed to research carried out by the FCA in May 2019 evidencing "the use of swing or dual pricing adjustments leads to significantly reduced redemptions from bond funds during periods of market stress".
The speech pointed out that many single-priced funds already partially use swing pricing, which allows funds to switch its valuation method from the ‘mid' price to the ‘bid' or ‘offer' price.
The second solution mentioned would be to introduce notice periods into funds, meaning extending the period between the time an investor submits a redemption request and the subsequent pricing and execution of that redemption request.
It was a solution suggested by Carney in December that was slammed as being potentially "complicated" and "confusing" for investors.
Schooling Latter admitted the two routes would contain complexities, including how long notice periods should be and difficulties in applying mechanisms to implement swing pricing.
"When extraordinary circumstances do occur… suspensions may be the best remaining option both for the fund's own investors and for the wider financial system," Schooling Latter conceded.
The FCA said it would consult with the industry and stakeholders on "the best mix of tools to ensure open-ended funds appropriately manage liquidity risks while enabling investments that can benefit fund holders and the wider economy".
Schooling Latter concluded: "We recognise that a daily redemption promise may be attractive for many fund investors. And for many funds investing overwhelmingly in highly liquid assets, this does not create a liquidity mismatch.
"We want open-ended funds to provide a structure through which investors can safely invest in less liquid assets which offer attractive expected returns and which supports investment that benefits the wider economy.
"Recent experiences may help rational and well-advised investors to recognise that daily redemption funds are unlikely, however, to be the safest or most profitable way of investing in less liquid assets
"We think now is the right time to work with you to address this, and make progress on embedding the right structures for open-ended funds investing in such assets."