Reaction to FCA’s illiquidity paper: Daily dealing and investor education named key issues

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The FCA’s discussion paper on open-ended funds investing in illiquid assets has received a mixed reaction, with some market commentators calling for the FCA to restrict daily trading in such funds while others maintain it is providers’ duty to explain the associated risks to potential investors.

The consultation follows the liquidity issues that arose as investors fled from property funds after the Brexit vote, and covers illiquid assets such as land and buildings, infrastructure and unlisted securities.

Measures mooted by the regulator include: a minimum buffer of liquid assets; applying different terms to retail and institutional investors; restricting other funds that can invest in the vehicles; enhanced disclosure for investors, increased governance of illiquid assets and creating a secondary market of open-ended funds’ units.

Ryan Hughes, head of fund selection at AJ Bell, says: “The investment industry has moved to a point where offering daily trading on a fund regardless of the asset class has become the norm. While this optically helps customers, it creates other problems where we see high levels of cash held to offset the liquidity risk. The liquidity problem is solved, but the side effect is increased cash drag and poorer performance.

He adds: “The ideal scenario may be that the FCA, fund management industry and customers accept that offering daily trading in illiquid assets is not the right approach and ultimately not in investors best interests. The trouble is that there is no advantage for any fund manager moving first on this issue. This will only be solved by the FCA taking a strong lead.”

Jake Green, regulation partner at law firm Ashurst, warns the FCA’s proposals could lead to funds being further subjected to scrutiny by the regulator.

He says: “Many might see this as the thin end of the wedge and further product intervention possibly for professional investors who are comfortable with the status-quo and related risks.”

Guy Morrell, manager of HSBC’s Global Property fund, says redemptions and illiquidity are not “an intrinsic problem with property as an asset class” but says investors’ expectations should be managed.

“I think investors need to be aware of the characteristics of their investments, including the illiquidity of buildings and provisions to suspend redemptions in unlisted property funds.

“As we saw in the wake of the Brexit vote, some investors wanted to exit the commercial property sector quickly, but realised that this wasn’t immediately possible. I don’t believe that this was an intrinsic problem with property as an asset class, but rather about investors’ expectations around of how quickly they could sell fund holdings in unusual market conditions. Buildings are illiquid and investors need to ensure that prospective returns offer sufficient compensation for this illiquidity.”

Laith Khalaf, senior analyst, Hargreaves Lansdown, believes investing in commercial property investment is more suited to closed-ended funds, but says for open-ended funds, dealing will have to suit both investors and the illiquid assets.

He says: “Any effective solution will probably have to strike a compromise between the demand from investors for regular dealing and the illiquid nature of the assets held in these funds. Even then there are no guarantees such measures will prevent the same problems resurfacing in future.

“We remain of the view that commercial property investment is more suited to closed-ended funds, but where investors are advised to buy open-ended funds, the illiquidity risk must be clearly explained upfront so they are going in with their eyes open. Fostering a long-term approach to investing also helps investors to see past periods of market turmoil, like the one we witnessed in the commercial property sector last summer.’

The Association of Real Estate Funds welcomed the FCA’s proposals. Chief executive John Cartwright says: “The discussion paper is a timely development for the property funds industry and follows on from our own work to maintain a regulatory landscape that works in the best interests of its clients.

“Last year, the Association of Real Estate funds commissioned an independent report to assess the impact of the UK’s decision to leave the European Union on the real estate market and evaluate whether any improvements to regulation or fund structures could be made. The primary focus of this research, which is due to be published for public consultation in March, is to ensure that our industry continues to provide comprehensive investor protection and deliver the best possible outcomes for our clients.

“We look forward to working with the FCA to identify any areas where ‘best practice’ could be established, either by the industry itself or by the regulator.”