Investors in Woodford Equity Income fund are in an unfamiliar and uncomfortable situation, temporarily locked into the fund and unable to liquidate their holding. It will be of little consolation to them that regulators have, for some time, been alive to the factors underlying why the fund has suspended dealings.
On the February 5, European regulator the European Securities and Markets Authority (ESMA) issued a consultation paper which cited two issues that have increased regulatory focus on this issue:
- The sharp growth of the asset management industry (measured by total net assets) since the mid-2000s, which has increased the potential impact of asset management activities on the broader market; and
- An increased focus on the potential "liquidity mismatch" in many investment funds, whereby units in funds are sometimes dealt and settled in a shorter timeframe than the fund’s assets can be reasonably liquidated
This second bullet prophetically sums up what has happened with the Woodford fund - it is an open-ended fund, which was offering daily dealing to clients when it was holding assets which could be bought and sold on a daily basis.
The Woodford fund, along with the majority of retail funds bought by European retail investors, is a Ucits fund – that is to say, it operates under a set of rules established in the European Union 30 years ago, which include a number of clauses related to liquidity.
Firstly, the rules state that funds must invest in "transferable securities or in other liquid financial assets" – for example, money market assets, bonds, shares and derivatives.
Secondly, a Ucits fund must be diversified. This is principally enforced by what is known as the 5/10/40 rule, which stipulates that a maximum of 10% of a fund’s net assets may be invested in securities from a single issuer, and that investments of more than 5% with a single issuer may not make up more than 40% of the whole portfolio. A maximum of 10% of the fund can be invested in unlisted securities.
Thirdly, and most directly related to liquidity, a Ucits fund must allow investors to buy or sell shares at least twice a month. In actuality, most offer daily liquidity, and to do so, must be able to sell enough of the funds holdings to pay back those investors redeeming on any given day.
Esma updated its code of good practice last year and the FCA has also done work on the subject. In the US, a new rule implemented by the regulator, the SEC, took effect this month for large asset managers this month requiring funds to classify each of their holdings into four liquidity categories – highly liquid, moderately liquid, less liquid and illiquid - based on the number of days the fund reasonably needs to raise cash to meet investor redemptions without significantly changing the market value of the remaining fund holdings. Illiquid assets are limited to 15% of a funds’ net assets.
Applying similar estimates to the Woodford fund, using Morningstar tools, shows that, on a very conservative basis, potentially only 30% of the portfolio could be redeemed after one year. This be increases to around 80% when more generous assumptions are used. The details of this research are explained in detail in this Morningstar report.
To expedite the sale of securities to meet investor redemptions will almost certainly result in fire-sale prices for some securities, and that would impact on the fund's duty to act in the best interest of all investors – departing, incoming and ongoing.
By comparison, the portfolio of Aberdeen UK Equity Income could be liquidated much more quickly.
The temporary suspension that Woodford has invoked utilises a rule that exists to protect those interests of all investors and allows him time to transition the portfolio at the best, or least-bad, cost. While there is no maximum duration for the suspension it has to be reviewed at least every 28 days and investors kept informed.
The size and profile of the fund is almost certain to add to and inform the regulatory reviews in progress.
