The FCA’s recently published discussion paper on open-ended funds with illiquid assets suggests a radical change that could alter the way funds are structured.
The genesis of the FCA’s (Financial Conduct Authority) review of open-ended funds with illiquid assets can be traced back to the aftermath of the Brexit vote last June, when a number of large open-ended property funds suspended trading. An estimated £18 billion of fund assets were frozen due to exceptional investor redemption requests that could not be met due to the liquidity mismatch between the funds’ redemption cycles and the underlying property holdings.
The FCA’s discussion paper contains a number of proposals designed to help open-ended funds with illiquid assets manage redemption requests more efficiently under exceptional market conditions, many of which are similar to the new liquidity rules being implemented in the US.
What’s unique to the FCA’s proposal is the suggestion to completely segregate retail and institutional investors in open-ended funds. If enacted, the segregation of investors could limit investment options, increase costs for both sets of investors, and further fragment the market, which already has too many small underperforming funds.
Should Retail and Institutional Investors Be Allowed to Mingle?
The FCA questions the appropriateness of commingling retail and institutional investors within the same fund structure, if the funds hold illiquid investments. The primary concern is that institutional investors have significant informational advantages over retail investors. In stressed market conditions, institutions tend to have first-mover advantage and can redeem quicker than retail investors. This means that retail investors could get stuck in rapidly depreciating illiquid funds. Another concern is that institutions usually hold much larger stakes in funds than retail investors, so if they divest, the fund immediately becomes more expensive to run and more susceptible to market volatility.
The Case for Pooling Investors
It is common practice to have both retail and institutional investors housed within the same alternative fund to make them more efficient and cost effective. If a mandatory split was enforced, it would have a significant impact on how investment funds operate.
Pooling retail and institutional investors creates economies of scale and encourages retail investor participation in investment funds by allowing asset managers to provide a range of investment strategies to retail investors at a reasonable price. Certain funds may become uneconomical to offer to only retail investors. This is particularly true for real estate funds, which require large amounts of capital to invest and therefore need institutional investors to make the funds feasible. A forced separation would result in many asset managers restructuring their products, closing uneconomical funds, or launching separate funds for retail and institutional investors.
The FCA publication closely follows the FSB’s (Financial Stability Board) assessment of liquidity mismatches between open-ended fund investments and investor redemption terms. The FSB’s report states “retail investors may overestimate the liquidity of the assets” in which they are invested. Both reports suggest that retail investors need to receive better information so they can properly assess the liquidity risks inherent when investing in funds.
Is a Review of UCITS on the Horizon?
The FCA’s proposal is limited to funds with illiquid assets. If the requirement was to expand beyond illiquid funds to include UCITS funds, the impact would be enormous since UCITS are designed to pool institutional and retail investments.
It is uncertain whether the FCA’s suggestion will implemented for illiquid funds, let alone extend to UCITS. However, the FCA is often at the vanguard of regulatory thinking and its policies tend to be replicated by other regulators. Since increasing investor protection remains a key priority for ESMA, it could conceivably pick up the baton and review these issue specifically or as part of the long-dormant UCITS 6. The discussion paper is open for comment until 8 May 2017. Given the potential repercussions of the FCA’s suggestions, this is an item worth monitoring closely.