Background

Investors were rocked by problems at household fund names, such as Woodford and M&G, last year. So here I take a quick look at what went wrong and how investors can mitigate the risk of a repeat.

Open ended nightmares?

Open ended funds were originally designed to achieve a degree of investor protection. However, there is a flaw in the way they are structured that can result in a fund suddenly having to suspend trading in its units (“gating”). It is this feature that has been causing all the recent trouble for investors.

Further, I would argue that this is not the only issue with open ended funds, but rather one of three that need to be more widely understood.

Let’s consider each briefly in turn.

Poor disclosure

You might think that a fund would do roughly what it says on the tin when it comes to investing your money. Yet the truth can be a little different. For example, a “UK income” fund may invest substantial amount into large, well-known income generating shares, but it may also run much less liquid positions too in companies many investors may know little about. The problem is compounded by the fact that many funds will only reveal information about their top holdings, claiming that to go any further would put their strategy at commercial risk. The result is it can be tricky for investors to discern what is really “under the bonnet” and therefore how much risk they are really running.

Gating

I have covered this before so will keep it short here. Open ended funds require investors to deal via the fund manager when it comes to buying and selling units. This helps to keep the value of the fund close to the total value of units issued. However, if a lot of investors want to suddenly sell units, this “safeguard” can create a liquidity issue if a fund manager cannot sell assets fast enough to satisfy them. Worse, the most liquid assets will tend to be sold first, leaving investors who remain in the fund potentially cornered in some pretty illiquid assets. The problem is summarised here – where will the £40m come from below to satisfy demand, given the fund only holds £20m in liquid assets?

The answer is the fund manager only has limited options in this situation.

Certain types of open-ended fund are more likely to suffer this problem, albeit it can affect almost any type of open-ended fund where the underlying assets are illiquid.

Fees

Unit trusts used to be cheaper than they are today – there has been considerable “fee creep” since the first one launched in 1935 and what’s more the structure of those fees has become more complex. This can make finding out the total level of fees difficult and therefore also muddies the water when it comes to comparisons.

Solutions

The FCA have tied to tackle the first of these issues in particular with a new set of disclosure requirements for less liquid funds. However, it is not yet clear whether this will be enough. Doubtful investors may want to consider some other courses of action.

Ways to invest

Anyone worried by the events of last year could consider three routes to achieving a diversified exposure, all of which I have covered previously as Killik Explains videos. Each has its pros and cons, so you may also wish to discuss them with an Adviser. There is also further information available in the Winter 2020 issue of Confidant on pages four and five. In summary;

·       Stick to open ended funds that make good disclosure about what they hold

·       Consider an alternative structure that achieves a similar aim, such as an Investment Trust

·       Look at direct equity investing within a portfolio

To find out more

Feel free to email me on editor@killik.com.