Could UK Smaller Companies funds be vulnerable to liquidity mismatch?

Brexit, UK, European Union, EU

A number of funds in the UK Smaller Companies sector would take more than two weeks to meet redemptions worth 20 per cent of assets under management, new research has revealed.

According to the SCM Direct report the £468m Liontrust UK Smaller Companies fund would take 29 days to reach such a level of redemptions, making it the most illiquid among funds analysed in the sector.

It was followed by the £434m Schroder UK Dynamic Smaller Companies and £581m Smaller Companies funds, which would take 27 and 19 days respectively to meet 20 per cent redemptions.

The report says many advisers place too much emphasis on volatility risk rather than liquidity risk when it comes to fund investing.

It states that many property funds received low risk ratings under the FE Analytics Risk Score, which measures volatility relative to the FTSE 100 index, even though they faced suspensions following the UK’s vote to leave the European Union.

The Threadneedle UK Property fund, for example, has a risk rating of 34, compared to the FTSE 100 rating, which is rated at 100. The Henderson UK Property fund has a score of 38 and the Aviva Property Trust has a score of 41.

Tilney Bestinvest managing director Jason Hollands says “it shouldn’t surprise anyone” that funds with large exposure to Aim companies or micro-caps will be less liquid than those with exposure to the FTSE 100 or mid-caps.

But he adds that he is not aware of any fund in the sector having to suspend trading in the aftermath of the EU referendum.

Hollands says it would be an “extreme set of circumstances” that would require smaller companies funds to liquidate 20 per cent in five days. He adds that property funds could never liquidate a 20 per cent position in such a timeframe.

“There is of course always a potential “what it” scenario where market conditions become so extreme that dealing liquidity dries up in all manner of asset classes.

“The global financial crisis when the whole financial system teetered on the brink is working example.

“At that time  it was money market funds – particularly enhanced cash funds –  commercial property funds and funds of hedge funds that ended up gating investors.”

Schroders says it has pricing mechanisms on all funds to ensure the interests of redeeming and remaining clients are protected. It adds that it actively manages capacity to ensure liquidity is not compromised by taking on too many assets.

A spokesperson says: “In small cap stocks in particular we often find that liquidity is underestimated for two main reasons; firstly as large holders of stocks we often create liquidity through trading, and secondly because trading avenues are available to us which don’t get captured in published liquidity data. 

“Therefore in practice we are often able to trade considerably larger blocks than liquidity analysis alone would suggest.” 

A spokesperson from Lionstrust also says the analysis underestimates liquidity stating it uses techniques relevant for larger companies, which is inconsistent with trading in small caps.

They add that the single largest investor holds less than 5 per cent and that the Key Investor Information Document “clearly states the risk of investing in small companies”.

The report says it would be “prudent” for the FCA to encourage advisers and fund groups to look beyond share price moves when it comes to assessing fund risk and suggests a fund that takes a week to sell 10 per cent of assets should have weekly subscriptions.

Other funds that would take more than two weeks to meet redemptions worth 20 per cent of assets include the Miton UK Smaller Companies fund and the Marlborough UK Micro Cap Growth fund.

The research analysed funds with assets over £100m and used data collected from Bloomberg in September to determine how long it would take to meet redemptions of 10 per cent and 20 per cent of assets.