Open-ended funds: open to change?

Many thought the UK would remain in Europe. And those that did not believed they were prepared for redemption requests in the event of a vote to leave. Well, three of them did anyway.

In April, Aberdeen Asset Management, F&C and Legal & General revealed they were holding more cash than usual as they prepared for outflows. However, they were the cautious few, and even they could not protect themselves from what has happened since 23 June.

At noon on Monday 4 July, after 11 days of mayhem politically and on the stock markets, Standard Life Investments declared it had suspended its UK Real Estate fund as redemptions flooded in. Seventy two hours later, seven funds collectively managing around £15bn of property had closed the gates.

This week, it was revealed that the Bank of England had been warned at meetings on 28 June and 1 July of the outflows from retail funds and that funds might be suspended in the wake of the Brexit vote. So why couldn’t last week’s spate of suspensions be prevented?

Could this turn into another mis-selling scandal? And should the model be changed so such funds resemble open-ended institutional funds, which are traded monthly or quarterly rather than daily?

What makes last week’s events – and the subsequent forced sale of assets – so galling for many is that it is not the first time this has happened.

Several property funds were forced to suspend redemptions during the financial crisis of 2008, as investors sought to withdraw money at a rate faster than properties within the funds could be sold.

But, despite warnings that the promise of daily liquidity should not be made as property is essentially an illiquid asset, the Financial Conduct Authority (FCA) ignored calls for regulatory changes.

Now it is coming under pressure once again to review the rules and do what many feel should have been done eight years ago: namely protect individual retail investors from themselves.

John Forbes, a leading consultant in the property fund arena, was one of those lobbying for change following the last financial crisis. In 2012, a paper he authored for the Association of Real Estate Funds (AREF) was delivered to the FCA as part of the organisation’s call to change the way open-ended funds were regulated.

One of the key points from Forbes’ report was that there is a trade-off between liquidity, volatility, performance and risk. “There is an increasing recognition of the consequences of this and many managers of open-ended funds have, with the support of investors, moved to place restrictions on absolute liquidity by limiting the capacity for investors to redeem their units,” he says.

“This is starting to become a spur to product development. Unfortunately, this is not reflected in the regulations.”

More choice needed

When AREF lobbied the FCA to bring in tighter regulations and give retail investors more choice, the regulator felt that the benefit of liquidity outweighed stability and left things as they were.

“It’s liquidity versus stability,” says Forbes (pictured). “I believe that retail investors would benefit from better governance of funds, as well as being given wider choices in the market.

“After the last crash, those funds purely for institutional investors looked at how they operated and created more long-term investment vehicles.

“They are still open-ended, but not as open-ended as retail funds, and with better governance, longer-term objectives and an element of liquidity, these funds are better protected against such panic runs.”

For Forbes, the lack of choice for retail investors is a key point. “Sure, the liquidity is good, but it’s not good when the funds are suspended,” he says.

“Retail investors should, like institutional investors, have longer-term, higher-yielding funds to choose from, where they may have to wait a year or so to get their money, but it’s safe, well governed, and gives them more back in the end.”

Root-and-branch review of regulation

The industry needs to sit down with the FCA in the autumn “after the dust has settled” and conduct a root-and-branch review of the regulation of property funds, believes Forbes.

“We can’t have the usual quick fix that just introduces more problems,” he adds. “The regulation of UK property funds is a nonsense. It needs a full and considered review, and something must be done, or this will keep happening.”

While John Cartwright, the chief executive of AREF, will not commit to lobbying for further regulation as the organisation did four years ago, he agrees that a discussion on how property funds are managed is needed. “It’s something we should look at objectively when the current period is over,” he says.

“Our view is the funds have done what they are meant to do under the current regulation. They have protected investors, and are taking a breath to have an orderly sale of some of their assets in order to raise cash and create a stable environment.

“But just because the system has worked as it should under the current rules, that doesn’t mean we shouldn’t have a look at how the funds are regulated.”

No knee-jerk reaction

However, Cartwright also warns that the drama of recent weeks should not be used to justify change for change’s sake. “Open-ended funds have been around for over 40 years, and issues like last week are rare,” he says.

“Having daily priced property funds is not a new thing at all. There shouldn’t be a knee-jerk reaction to recent events. We should act in a measured way, and when things have calmed down we will sit down with our members and consider what, if anything, can be done in terms of regulation.”

Cartwright suggests that there could be a system by which retail investors are charged higher fees if they demand their cash back immediately. Others suggest that what is needed is better education rather than more regulation.

Claire Madden, managing partner at Connection Capital, believes retail investors may need better and clearer information before making the decision to invest in open-ended property funds.

“I’m not entirely sure regulation is required,” she says. “I think investors need to be a lot more grown-up and better informed about what they’re investing in.

“Whether it’s been made clear to [investors] by financial advisers that they can have their cash locked up if they join a panic and try and withdraw their cash along with many other retail investors, I’m not sure,” she says. “If they are not aware of this, then it’s down to the FCA to ensure that financial advisers do inform retail investors of the risks.”

The consequences could be dire if they are not made aware. One fund manager warns that firms could be fined. He also fears another mis-selling scandal.

“People putting money in don’t have any idea what they are in for. There need to be changes to how these funds are sold and greater transparency,” he says.

Others are concerned there will be a repeat of what happened in Germany after the last financial crisis, when many open-ended funds disappeared.

“A lot of UK funds have continued on without any apparent change in the way they are structured,” says another manager. “You can’t be promising to offer daily liquidity when real estate is essentially illiquid.”

The City is understandably wary of new regulation, but many now accept that new regulation is at least needed to ensure funds hold sufficient cash to cover them in the event of another panic.

It is also aware that the funds have ridden their luck twice now. Third time around, they might not be so fortunate.