The suspension of the Woodford Equity Income fund has been a stark reminder to investors of just why investment trusts have historically been the go-to vehicle for accessing illiquid assets.
Regardless of sentiment, performance or how many investors want their money back, an investment trust will not be forced into a fire-sale of its assets or to shut its doors and suspend trading. Morningstar analyst David Holder says: “The closed-end structure of an investment trust is an ideal home for illiquid or specialist assets and much of the issuance in recent years has been focused on these more niche areas.”
One of the fundamental differences between an open-ended fund and a closed-end fund (also known as an investment trust or investment company) is the way you invest. With an open-ended fund, investors buy units. These are created and destroyed in line with supply and demand, so investors can keep putting more money in and the fund can continue to grow its assets.
With a closed-end fund, investors buy shares. There are a finite number of these in issue and the manager therefore has a set amount of assets to invest. When more investors are keen to put money in a trust, more shares are not created but the price of the existing shares goes up.
When a closed-end fund falls out of favour and investors want to sell, the share price falls but, crucially, the total amount of money the manager has to invest does not.
Forced Sales
With an open-ended fund, however, a manager must sell assets, such as company shares, to free up enough money to give back to investors who want to sell their holdings. As a result, the total amount of assets in the fund reduces. Woodford Equity Income is an extreme example of this; at its peak the fund managed £10.2 billion of investors’ cash, but when it suspended trading its assets had fallen to £3.7 billion.
This becomes an issue when a manager cannot sell his assets quickly enough to meet investor redemption requests. Selling holdings is not usually an issue if you’re investing in FTSE company shares or on a similar stock market – you can typically always find a buyer, even if you don’t quite achieve the price you had hoped for, and trading can take place instantly.
But other assets can take longer to sell and may not be so easy to price. For example, property funds own entire office blocks, shopping centres and warehouses, so buying and selling these assets can take months. If you are forced to sell them in a hurry you will likely have to accept a much lower price than you usually might.
Open-ended property funds typically hold a chunk of their money in cash so they can manage investor inflows and outflows. But in extreme periods, this isn’t enough – after the EU referendum in June 2016, property funds suspended trading to stop a flood of investor redemptions prompted by fears the property market would crash. Closed-end property funds saw their share prices fall by as much as 70% but investors were not stopped from buying and selling. It’s a commonly cited area where the structure of closed-end funds tends to fare better.
The same is true of infrastructure, renewable energy assets and esoteric areas of investment such as litigation finance or peer-to-peer loans. These are all assets which are not priced daily, can’t be bought and sold in an instant, and are not mainstream enough to ensure there is always a buyer or seller for the trade you want to make.
Finding a Buyer
This is also the case for investments in unquoted companies. These are businesses which do not yet trade on the stock market, so finding a buyer for a stake you wish to sell can take time, and so too can valuing the company.
The wave of property fund suspensions after the EU referendum was so extreme it prompted a consultation by the Financial Conduct Authority into the use of illiquid assets in open-ended funds. It proposed that funds investing in illiquid assets should have an “identifier” in their name to draw attention to the nature of the portfolio and that managers should have a contingency plan for dealing with liquidity risks.
Of course, investments trusts are not perfect. They are often perceived as being more complicated than open-ended funds, which can put some investors off using them. While investors will always be able to buy and sell shares in a trust, if the share price plunges, they will have to endure significant capital losses if they need to sell at that point. In the worst cases, a trust may see the value of its assets plunge and it could be forced to wind up.
Holder says: “A recent example was the sell-off in infrastructure funds in 2018, where the sector was adversely affected by the collapse of Carillion and the perceived increase in likelihood of a Labour government with a nationalising agenda.
“These trusts recovered but one area not so fortunate was the specialist real estate companies which launched in the mid-2000s and were, in many cases, engulfed by the global financial crises as a combination of high debt levels, frozen credit markets and falling net asset values lead to many imploding and winding up.”
Watch our video on investing in illiquid assets here
