July 1, 2019

Monday Morning Memo: Don’t Panic About Illiquid Holdings in Mutual Funds

by Detlef Glow.

The closure of the Woodford Income Fund has led to wide discussion about illiquid holdings in mutual funds. As a result of this discussion, asset managers have come under pressure as investors have begun to sell positions in funds in which they have identified illiquid holdings. Even as this reaction is in some cases understandable, the high level of outflows in some funds is surprising, since some of these funds now under pressure were quite clear about these holdings. Even if they weren’t, these holdings shouldn’t be a surprise to professional investors or advisors, since it is one of the duties of a fund analyst to evaluate the investment style of a fund manager and the respective risk of the portfolio to conduct an appropriate recommendation.

Past Performance as Selection Criteria

That said, I have witnessed that in some cases the funds which are facing criticism now have delivered superior returns in the past, which led investors into their portfolios in the first place. I’m not saying that all investors are just buying past performance, as we all know that past performance is no guarantee for the future performance of a fund. With regard to this, I am more than sure that the majority of fund selectors have quite complex and appropriate fund evaluation and selection processes and will, therefore, know what is inside the portfolios of their target funds. But I would question this for retail investors and their advisors, as these investors often work with recommendation lists and/or league tables to select their investments.

With regard to this, I personally find it questionable when rating agencies change the rating of a fund after such an event, even as the respective fund manager was not involved in any unexpected market or trading activity and didn’t change his investment style at all. Therefore, a robust and transparent qualitative rating process is key, as these independent sources of information are widely used by retail investors who trust in these ratings and respectively use them as guidance for their fund selection.

Is a change in regulation needed?

From my point of view, the rules of UCITS regulation are quite clear and able to protect investors in general. This means that the UCITS regulation provides a legal framework within which the asset managers can act, and the local financial markets authorities have to ensure that the asset managers and mutual funds under their supervision comply with these rules in the best interests of investors. With regard to this, it is not understandable that the Financial Conduct Authority (FCA) in the U.K. claims that it would imply changes to the existing fund regulation framework after Brexit to avoid these kinds of market events in the future.

All in all, it can be said that the Woodford case is not the first instance in which illiquid holdings led to the closure of a fund, and it will definitely not be the last. Some may say that the UCITS regulation needs to be adapted, but in practice the 10% bucket for non-listed equities is needed to efficiently manage portfolios. As long as the respective portfolio manager is managing the fund in the best interest of the investors, these holdings are not a threat.

The only way to avoid the current circumstances is through more transparency at the fund level and sufficient supervision from market authorities. In addition to this, it is important that fund selectors, market observers and rating agencies need to revisit the investment strategy and the respective portfolio of the funds they are rating or recommending regularly, especially when these funds appear on recommendation lists for retail investors.

The views expressed are the views of the author, not necessarily those of Lipper or Refinitiv.

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