Fixed Income

This week the £341 billion fund manager M&G Investments announced it would block redemptions on its flagship property fund. As at 31 October, the fund had £2.5 billion under management, having paid out £992 million of investor redemptions in the previous 12 months. The fund’s return of -8.2% over the last year would be at least in part due to the forced sale of a significant portion of its assets in order to meet the run of redemptions. The ructions in the UK office property market in the face of Brexit and the decline in bricks and mortar retail also put downward pressure on the asset valuations.

This lock-up follows hot on the heels of the demise of the £3.7 billion Woodford Equity Income Fund. This fund had concentrated holdings of highly illiquid stocks listed on second and third tier stock exchanges. Whilst the fund claimed it was liquid as the stocks were listed, some of its stocks rarely traded and were akin to private equity holdings.

In both cases, poor performance started a run of redemptions. The requirement to sell down holdings to meet the redemption requests added to the performance problems as illiquid holdings typically need to be sold at a discount to their book value when a rapid sale is required. Media reports of high levels of redemptions lead to further redemptions as investors fear being left holding the bag if they don’t make an early exit.

Whilst some might want to dismiss these examples as just a UK problem, they are yet another reminder that illiquid assets in open ended funds are a disaster waiting to happen. Wind back the clock ten years and Australia saw the majority of its open ended mortgage, high income and property funds lock up. Almost all of these funds were eventually wound down, often taking three to seven years to return investor’s capital. These sectors left a graveyard full of dead funds with only a handful of survivors still operating today.

Despite this history, Australian investors are charging back into open ended funds, particularly in the credit and property lending space. Every time the RBA cuts the Cash Rate another torrent of money starts looking for a new home that can deliver a positive return after factoring in tax rates and inflation. Unlisted property syndicates and direct ownership of investment property (both residential and commercial) are favourite hotspots for yield chasers. The wave of ASX listed hybrids and listed investment trusts focused on private debt are others, with the growth of these two sectors being boosted by sales commissions.

All these options come with the risk that investors could lose a meaningful portion of their capital in a substantial downturn. What sets open ended funds apart is investors can become captive to the actions of other investors. If enough investors ask to redeem, all remaining investors can be forced to exit their positions at a time and price that is sub-optimal. Those who planned to be long term investors can be dumped out of their positions at a time when they would never have chosen to sell. Those who planned to be short term investors are forced to stay around for an unknown length of time whilst their fund winds down.

The flip side of these risks is the opportunity for other investors to buy once in a generation bargains from forced sellers. Whilst this requires enormous discipline to execute, well prepared investors can make a decade’s worth of outperformance in a few years. The preparation to execute this strategy begins now, with long dated and high risk positions exited whilst the market for low quality securities is wide open.