Open-end funds investing in less liquid assets pose a major risk to global financial stability, the International Monetary Fund has warned.
Unit trusts and open-ended investment companies (OEICs), which are mutual funds that allow investors to buy or sell their shares at a daily set price, are vulnerable to the waves of investor withdrawals that have often followed economic shocks, the IMF said in an online post accompanying its latest global financial stability report, meaning the multi-trillion-dollar industry presents a “major potential vulnerability” of the financial system.
It noted that similar conditions had been seen in the wake of the UK government’s backfiring ‘mini budget’ and at the time of the initial Covid outbreak, where open-end funds were “forced to sell assets amid outflows of about 5% of their total net asset value” both times topping the redemptions seen in the global financial crisis.
“Consequently, assets such as corporate bonds that were held by open-end funds with less-liquid assets in their portfolios fell more sharply in value than those held by liquid funds,” the Washington-based organisation said.
“Such dislocations posed a serious risk to financial stability, which were addressed only after central banks intervened by purchasing corporate bonds and taking other actions.”
Fifth of the market
It noted that the structure of these funds, which differs from other types of funds such as the closed-ended design of investment trusts, is a big part of the problem.
While this is not a new issue – with the open-ended structure part of the problem for the collapsed Woodford fund and a wave of property funds that have been suspended in recent years – the IMF said with the rise of interest rates and high economic uncertainty it felt it should issue an alert.
OEICs have grown significantly in the past two decades, with US$41trn of assets now held in them around the world, representing roughly a fifth of the non-bank financial sector’s holdings.
The leading fund management companies in the UK as of April by value of OEIC funds under management, according to Statista, were Royal London, Fidelity International, Baillie Gifford, Link Fund Solutions, Abrdn PLC (LSE:ABDN), HSBC Holdings PLC (LSE:HSBA), Scottish Widows (part of Lloyds Banking Group PLC (LSE:LLOY)), Vanguard, Threadneedle and BNY Mellon (NYSE:BK). Other notable listed players include Aviva PLC (LSE:AV.), Legal & General Group PLC (LSE:LGEN), M&G PLC (LSE:MNG), Jupiter Fund Management PLC (LSE:JUP), Premier Miton Group PLC (AIM:PMI), Impax Asset Management (AIM:IPX), Liontrust Asset Management (LSE:LIO), while OEICs are a major product for investment platforms Hargreaves Lansdown PLC (LSE:HL.), AJ Bell PLC (LSE:AJB) and interactive investor (part of Abrdn).
As central banks raise rates, the IMF pointed out that “disorderly tightening of financial conditions could trigger significant redemptions from these funds and contribute to stress in asset markets”.
For OEICs that hold hard-to-sell assets but offer daily redemptions, with “can spark volatility and magnify the impact of shocks, especially in periods of market stress”, it added.
While it said these funds are “an important component of the financial system,” the huge size of the sector now should require governments and regulators to consider “tighter monitoring”.
Measure suggested included more monitoring of liquidity management practices, additional disclosures by OEICs to better assess vulnerabilities, encouraging more trading through central clearinghouses, and making bond trades more transparent.
Following chancellor Kwasi Kwarteng's fiscal statement on 22 September, there was £5.97n in net outflows from Investment Association (IA) funds by the end of the month, according to estimates from Morningstar.
With retail investors panicking as the pound crashed to record lows and with a breathtaking selloff of UK government bonds, this saw fund withdrawals in one week not far from the record monthly outflow of £10bn seen in March 2020 when investors reacted to the first Covid lockdowns.
This week, Schroders, BlackRock and Columbia Threadneedle as good as suspended withdrawals from their property funds as they said they were not able to handle the heavy level of redemptions.
Structural issues
As the IMF noted, investors can sell shares or units of the funds daily at a price set at the end of each trading session, “but it may take fund managers several days to sell assets to meet these redemptions, especially when financial markets are volatile”.This can be a big problem for fund managers during periods of great outflows, especially those holding illiquid assets such as property and unquote stocks, which can often take many months to offload.
Suspensions often follow, in order to give the fund manager time to ensure there is enough liquidity in the fund to meet redemption requests.
As a result of hurried and forced sales, the price paid to investors “may not fully reflect all trading costs associated with the assets they sold”, the IMF noted.
“Instead, the remaining investors bear those costs, creating an incentive for redeeming shares before others do, which may lead to outflow pressures if market sentiment dims.”
The risk of a suspension gives an incentive for investors to be among the first to redeem during times of volatility, creating the risk of a ‘run’.
The IMF and JPMorgan is not alone in being concerned about the risks of putting illiquid assets into open-ended funds, with former Bank of England governor Mark Carney said these funds were “built on a lie” and were “something that could be systemic”.
The UK Financial Conduct Authority has been consulting on proposals to reduce the potential for harm to investors from the “liquidity mismatch” in open-ended property funds since the collapse of the Woodford Equity Income fund in 2019 and mass property fund suspensions after the Brexit vote and other times of market stress.
But it has not delivered a decisive solution yet, with its last update being in May 2021.
Naturally, the trade body for closed-ended funds – better known as investment trusts, is also keen to point out the potential hazards of open-ended funds, including in a report entitled 'square peg in a round hole'.
“As well as being bad for investors trapped in troubled funds, it creates dangerous ripple effects throughout the financial system as the IMF has rightly pointed out,” said Nick Britton, head of intermediary communications at the Association of Investment Companies (AIC).
“Closed-ended investment companies, on the other hand, have no need to sell assets when investors sell their shares. Their stock market listing provides a safety valve, allowing those investors who want to exit during a downturn to do so (albeit at a knock-down price) while not penalising those who prefer to stay invested.”