Fitch Ratings has warned investors should be wary of investing in open-ended funds that have exposure to assets with limited liquidity.
The ratings agency said there is “structural weakness” in mutual funds which has been highlighted by the suspension of the £3.7bn Woodford Equity Income fund.
The fund, which launched to much fanfare in 2014, was forced to suspend trading following a string of withdrawals caused by concerns around its performance throughout 2018 and its exposure to unlisted holdings.
The firm said in a statement the move was “in the best interests of all investors in the fund” and gives star fund manager Neil Woodford (pictured) “time to reposition the element of the fund’s portfolio invested in unquoted and less liquid stocks, in to more liquid investments”.
According to FE, the fund has returned -11.3% over the past three months and -18.1% over the past three years versus 23.3% returns for IA UK All Companies sector, as at 5 June.
Fitch commented: “Open-ended funds with exposure to less-liquid assets have a liquidity mismatch given the daily liquidity they offer to investors.
“They may, therefore, face liquidity pressure if there is a spike in redemptions, potentially leading them to block withdrawals so that they do not become forced sellers of illiquid assets, and to prevent a run on the fund.”
This also occurred with UK property funds in 2016. After the UK voted to leave the European Union in June, open-ended UK commercial real estate funds were forced to suspend trading amid an increased number of redemption requests.
“The Woodford Equity Income fund gating could significantly damage the reputation of its investment manager, Woodford Investment Management Limited, particularly given its labelling as an equity fund,” Fitch added.
The creation-redemption mechanism in a mutual fund is flawed as the issuer is always a forced seller when investors want to redeem.
This means when there is a run on the fund and it is invested in illiquid holdings, like the Woodford Equity Income was, the issuer is unable to sell the fund’s holdings and is then forced to suspend trading.
Creation-redemption works differently with ETFs as they are not created using cash. Instead, an ETF provider takes a basket of shares from a market maker – an investment bank such as Citi – in exchange for the ETF. This creation means the ETF issuer is not a forced seller as there is no cash involved in the transaction.
However, the weakness with this is the market marker can embed their own costs into the transaction when the ETF is swapped for shares.