July 30, 2019

How Should Investors View a Mutual Fund Suspension?

by Jake Moeller.

The recent announcement that one of the best-known fund managers in the U.K., Neil Woodford, has had the suspension of his flagship LF Woodford Equity Income Fund extended may be unwelcome to those investors who currently hold units in the fund.

Why invest in mutual funds in the first place?

Mutual funds are a popular form of collective investment which allow investors to own a proportion of an instantly diversified pool of investments held by an independent custodian.

Many investors do not have the time or resources to build up a researched share portfolio and rightly believe that they might be exposed to too much stock-specific risk. For them, the mutual fund solution (in either an active or passive approach) might be the best solution.

The instant diversification and general subsequent reduction in unsystematic risk of a mutual fund is ostensibly the greatest benefit. Investors are, however, still potentially exposed to other risks such as market, liquidity, and style risk.

Fund closures such as Woodford’s are unusual and rarely garner so much publicity. The noise surrounding this closure is amplified by Woodford’s reputation, track record, and the popularity of this fund.

However, it is worth reminding ourselves how mutual funds are designed and the built-in mechanisms which afford some investor protection.

What causes a suspension?

The travails of Woodford’s fund have been well documented, but any mutual fund may experience temporary suspensions. Where sustained and material outflows disrupt the day-to-day running of the fund to the detriment of remaining investors, suspension is an important defence mechanism.

Most mutual funds can meet normal client redemptions—a proportion of cash in the portfolio is often sufficient. Where there are many redemptions, they must be funded through the sale of securities in the portfolio.

Is portfolio management compromised?

If the portfolio is constructed of, say liquid large-cap stocks, this should not be a problem. Where the portfolio contains less liquid investments, it can potentially force the fund manager to sell these assets while simultaneously reducing their prices, further compounding performance issues.

Where a fund manager is exhausting liquid stocks to fund redemptions, this leaves an increasing proportion of illiquid stocks in the portfolio. The fund’s composition and style bias could be distorted considerably. It can also force a fund to potentially breach its mandate or regulatory requirements. A suspension prevents this problem amplifying.

Mutual fund investors—equality is important

Sometimes mutual funds will discourage large individual redemptions from a fund via a mechanism called a dilution levy—a charge applied to that specific client rather than across the mutual fund. A temporary suspension is another mechanism which will protect the investors who remain in a fund from the trading costs incurred by those who wish to leave. This is important when many investors are selling.

Why suspend?

A suspension gives a fund manager the opportunity to potentially restructure the portfolio without having to meet redemptions by selling underlying assets at a loss. It also allows a fund manager time to reassure investors and break a bad news cycle if that is also a contributory factor.

Importantly, it potentially allows the natural forces of the market to increase the value of constituent securities, addressing the most likely cause of the redemptions in the first place.

Many investors in the U.K. will be familiar with the temporary suspensions of funds exposed to commercial property prior to the Brexit vote in 2016. Most of those funds were trading normally within months and performance has since stabilised.

A suspension is essentially a “time out” for a fund manager to consider options for remaining investors and should not necessarily be a reason to panic.

Undoubtedly, any fund manager who is operating through a fund suspension faces challenges and there is no guarantee that investor sentiment, or the portfolio, can be turned around.

Suspensions are not ideal, but better than chaos

Investors should take some comfort that the mechanisms of a mutual fund (including suspension) aim to provide a chance for a fund to change its fortunes.

The wording of the specific announcement referred to above states that the extension of the Woodford fund suspension provides “a realistic amount of time for Woodford to complete a measured and orderly re-positioning of the Fund’s portfolio of assets ensuring that there is adequate liquidity whilst preserving or realising the value of the assets“.

It also concludes that this “would represent the best outcome in terms of value, time and fair treatment for all investors“.

Is there any silver lining?

The wording of the suspension extension announcement seems appropriate and appears to be in the best interests of remaining investors.

The fortunes of a suspended fund are not predictable. In the unusual and worst case where a mutual fund no longer remains viable, its structure and a suspension allow for the orderly unwinding of its assets. This at least gives remaining investors the likelihood of recouping some capital.

There will rightly be much more debate and analysis about how and why we got here, and it is very hard to provide comfort to any investor currently trapped in a suspended fund. However, a mutual fund structure affords more protection to an investor than if they were exposed materially to a single stock which went bust or a bond which defaulted.

 


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Disclaimer: 
This material is provided for as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice. This work is the opinion of the author, not Refinitiv. The author does not own shares in this investment.

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