Liquidity Crunch Mangles UK Equity & Real Estate Funds
Exodus from funds with illiquid assets forces more funds to block redemptions.
By Nick Corbishley, for WOLF STREET:
Equity and property funds in the UK saw withdrawals of £2.5 billion in July, taking total outflows in 2019 so far to £12.4 billion, according to Morning Star data. Equity funds, with total assets of £691 billion, were down £1.6 billion in July and £10.6 billion so far this year. In a broad flight to safety, money market funds experienced their sixth consecutive month of inflows while investors poured £428 million into Fixed Income funds.
Morning Star analysts blamed the outflows from equity and property funds on fears over a UK recession and a no-deal Brexit. But there’s also a structural element at work: the mismatch in open-ended equity and property funds that offer investors daily redemptions while investing in assets that can take weeks or months to sell.
Few funds are as illiquid by nature as commercial property funds, which suffered £2.2 billion of outflows in the first seven months of this year. Just two funds — M&G Property Portfolio and Aberdeen UK Property — accounted for 89% of the £417 million of outflows in July.
“The prices of commercial property – which accounts for most of these funds’ investments – are heavily influenced by the macro environment and if investors believe a downturn is ahead, they are less likely to invest in property funds,” said Morningstar analyst Bhavik Parekh.
At M&G Property Portfolio, the outflows recently turned into a torrent, which then turned into a classic run on the fund, and managers ended up blocking redemptions as they tried to offload properties in the portfolio, including British retail parks, offices and industry property. Selling these assets at survivable prices, rather than fire sale prices, can take months or longer.
The gating of the fund stoked fears of a replay of the chaos that briefly swept the UK’s property fund sector in the wake of the Brexit vote in late June 2016, when the value of commercial real estate in the City of London crashed 6% in just one month and six commercial real estate funds, including M&G, temporarily suspended redemptions as panicked investors rushed for the exits.
To try to prevent that from happening again, some open-ended property funds are penalizing investors who cash in their holdings by marking down the value of the underlying properties in the fund. The latest fund to do so, BMO Holding, said it has (in the industry’s jargon) changed its fund pricing from “offer” to “bid”, leaving investors who dare to sell the fund shouldering an instant loss of approximately 6.4%.
“With heightened uncertainty in the UK property market, in part driven by the increased risks of a ‘no-deal’ exit from the EU, a number of investors in the sector have looked to trim their exposure. As such, the fund has seen modest outflows,” said Guy Glover, fund manager of BMO UK Property.
It’s not just fear that is driving investors to withdraw their money from property funds; there’s also widespread disappointment at the dwindling returns on offer, due in part to the larger cash buffers the funds have had to build up to try to avoid a rerun of Summer 2016. In May, the average level of cash exposure for UK direct property funds reached 19.5%, up from 14.6% in May 2016, according to the FT.
In expanding their cash buffers, open-ended property funds now have less money on hand to invest in actual income-generating assets. Funds in the Investment Association’s UK direct property sector generated average annualized returns of 4.4% over the three years to the end of June — 42% less than the 7.6% returns notched up during the previous three-year period.
With a no-deal Brexit looming ever larger, funds can be forgiven for toeing a cautious line, especially in light of recent developments at the £3.9 billion Woodford Equity Income Fund (WEIF), where a run on the fund prompted its manager, former hedge-fund legend Neil Woodford, to place a ban on redemptions. Over 300,000 (mainly retail) investors were left trapped with no means of accessing their funds.
What many of those investors hadn’t realized was that although WEIF was offering daily liquidity, most of its assets were extremely illiquid. By the end of May, the fund’s holdings of lightly traded micro-, small- and mid-cap stocks accounted for 97% its assets, according to Morning Star data.
The suspension on redemptions at Woodford has already been extended until December as the fund struggles to sell those assets. WEIF has already fallen by 11.2% since the suspension, compared with a 1.5% gain on its benchmark index, the FTSE All Share Total Return. Fears are growing that it may never reopen at all.
The Bank of England in July reiterated a warning it first issued in 2015 about “the vulnerabilities associated with liquidity mismatch in funds that offered short-term redemptions while investing in longer-dated and potentially illiquid assets.” Aside from requesting a fresh review of open-ended funds, which are estimated to hold some $30 trillion in assets globally, the central bank has taken no other action.
Some investors appear to be already taking matters into their own hands by yanking their money from other open-ended equity income funds. So far this year, over £10 billion has been pulled from UK equity funds. The Silver-rated JOHCM UK Equity Income fund, one of the 10 worst performers in July, suffered its largest ever monthly outflows, with £257 million withdrawn from the fund in the month. Neutral-rated Majedie UK Equity suffered outflows of £200 million.
The UK is home to more than 3,200 open-ended funds, which have total assets under management (AUM) of £1.5 trillion, up from £484 billion a decade ago, according to the Financial Conduct Authority. If the current pace of outflows from these funds continues, or even picks up in the event of a no-deal Brexit, the risk,as Bank of England governor Mark Carney recently warned, could very quickly become systemic. By Nick Corbishley, for WOLF STREET.
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