Avoiding a run on your fund

Another fund manager had trouble with illiquid portfolio holdings this week. It’s starting to become a habit.

Neil Woodford’s woes with liquidity (see box below) have hogged the limelight recently. But this week, another – albeit less well-known – fund manager experienced his own liquidity-related panic. London-based H2O Asset Management, owned by French bank Natixis, operates a range of funds, with more than €30bn in assets under management (AUM) as of the end of April. However, early last week, an investigation by Robert Smith and Cynthia O’Murchu of the FT Alphaville blog into the holdings of six of the funds (all open to retail investors), effectively sparked a run.

Alphaville found that between them, the funds held about €1.4bn of “highly illiquid” bonds issued by firms owned by the “enigmatic and flamboyant German financier Lars Windhorst”, who has a pretty colourful past. Apparently as a result of this FT investigation, fund researcher Morningstar suspended its rating on one of the H2O funds (“Allegro”), due to concerns about the liquidity of said bonds. That, in turn, sparked an exodus by investors.

H2O does appear to have acted quickly to sell out of a large chunk of the offending bonds and to write down the value of those it still holds, noting “that the aggregate value of the illiquid bonds is now below 2% of its assets under management,” according to the FT. And yet between them the six funds in question shed more than €5m in value – about 30% of their combined AUM – by the middle of this week.

This, of course, is annoying if you own one of these funds – particularly as they had a pretty good record up until now – but what should other investors take from it? We’ve now seen Woodford, H2O, and a similar blow-up at Swiss asset manager GAM last year. Is this a systemic issue? One problem is that low interest rates and tough competition from passive alternatives have put pressure on active managers to take more risk. That can often mean trading in illiquid assets.

And while there are rules on the proportion of illiquid assets that a so-called UCITS fund aimed at retail investors can hold, these don’t always help. If you are hard up against the 10% limit, and someone then withdraws from your fund, the cash will need to come from the liquid 90%, but pure arithmetic means this will push the illiquid chunk above 10%. So in short, we wouldn’t be surprised to see other funds experience similar issues. What can you do? Liquidity is less of an issue for closed-ended funds like investment trusts, although you may have to sell at a steep discount (just look at Patient Capital Trust). But overall, the key is to make sure you understand what you own – and don’t buy anything until you do.


I wish I knew what liquidity was, but I’m too embarrassed to ask

Put simply, liquidity refers to how easy it is to buy or sell an asset without moving the price against you. For example, property – both residential and commercial – is an illiquid asset. It takes a long time to buy or sell, trading costs (from stamp duty to surveys) are high, you can never be quite sure of the price you’ll get (or pay) until the deal has closed, and if you want to sell in a hurry, you’ll have to cut your price to well below the theoretical “market value”.

On the other hand, shares in big, listed companies (“blue chips”) on the FTSE 100, for example, are very liquid. They are also “fungible” – ie, one share is the same as another, whereas each property is unique – so millions can change hands every day online. You can get a price almost instantly, and you can almost always find a willing buyer or seller, even in turbulent financial conditions.

The level of liquidity in a market can vary widely – for all but the most liquid assets, it’s wise to assume that it will dry up at the worst possible times. In times of turmoil it may even evaporate altogether. For example, one big problem in the lead up to the 2008 financial crisis was that liquidity in the market for securities backed by subprime mortgages dried up entirely, and the securities were essentially unsellable.

Stocks in smaller companies can also be highly illiquid – when the market is volatile, the “spread” (the gap between the price at which you can sell and the price at which you can buy) might widen sharply, making trading more costly. Indeed, in the very worst panics, only “safe haven” government bonds, such as US Treasuries and UK gilts, may remain as liquid as they usually are.

Illiquidity is not in itself a problem. You usually get paid more to hold illiquid assets. The real problem only arises when you own an asset that turns out to be a lot less liquid than you expected – hence the scandal over funds that promise investors daily liquidity while holding an illiquid portfolio.