Liquidity Crisis at Woodford Equity Fund Is Symptomatic of Systemic Problem, Bank of England Warns

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$30 trillion of assets globally are held by similar open-ended funds.

By Nick Corbishley, for WOLF STREET:

The Bank of England warned on Thursday that “financial stability risks are increasing” from giant open-ended funds, which are estimated to hold some $30 trillion in assets globally. These funds are vast sources of financing for the real economy but can pose a systemic risk since the money often goes into assets that are hard to sell quickly, the central bank said in its latest Financial Stability Report.

If investors in an open-ended fund decide to pull their money en masse, which they’re ostensibly allowed to do at just about any time, the fund could struggle to liquidate its assets in time, especially if those assets are not very liquid.

This is exactly what has happened at the £3.7 billion Woodford Equity Income Fund, where a slow-motion (but accelerating) run on the fund prompted its manager, hedge-fund legend Neil Woodford, to place a ban on redemptions to avoid the risk of a fire-sale of its assets, below market value, against the interest of remaining investors. Since then, hundreds of thousands of investors, including public pension funds, have been unable to access their money.

The Bank of England’s Financial Policy Committee (FPC) already warned 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.” But no action was taken.

Now, the FPC says the Bank of England and the Financial Conduct Authority (FCA) will review how funds are able to offer daily redemptions while pouring money into assets that can take weeks or months to sell in an orderly fashion. “This can create an incentive for investors to redeem when they expect others to do so,” the FPC said, adding that this mismatch in liquidity “has the potential to become a systemic issue”.

In the case of Woodford, he was able to circumvent a 10% limit on illiquid assets by bundling up his fund’s unlisted assets and listing them on the minuscule Guernsey-headquartered International Stock Exchange, which has barely any trading activity at all and cannot provide liquidity to illiquid assets.

But it didn’t take long for investors to smell a rat. The total amount under management at Woodford has steadily shrunk by almost two thirds since 2015, from £10.2 billion to £3.7 billion. In early June, a request by Kent County Council to withdraw £250 million — the equivalent of around 4% of the total investments of its £6.4 billion pension fund — was the final straw. Instead of releasing the funds, Neil Woodford slammed the doors shut.

Bank of England Governor Mark Carney warned last month that funds like Woodford’s were “built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid. That leads to an expectation of individuals that it’s not that different than having money in a bank… This is a big deal. You can see something that could be systemic,” he said.

In the UK alone, there are more than 3,200 open-ended funds managed by nearly 200 Authorized Fund Managers. According to the Financial Conduct Authority, they have total assets under management (AUM) of £1.5 trillion, up from £484 billion a decade ago. At the global level, open-ended funds hold more than $30 trillion of assets.

The Bank of England’s review of open-ended funds will consider the potential pros and cons of having longer redemption periods for funds holding assets that are hard to sell. At the very least, “a funds’ assets and investment strategies should be consistent with their redemption terms,” the bank says. “Such alignment would directly address the structural cause of liquidity mismatch and help prevent problems from arising in the first place, rather than mitigating problems as they crystallize.”

The G-20 sponsored global financial regulator the Financial Stability Board has also flagged concerns that a large enough run on a fund could trigger a destabilizing fire sale of assets. But attempts to coordinate action at the international level have so far come to nothing.

The Woodford Equity Income Fund isn’t the only fund to have suffered major liquidity issues in recent weeks. In June, London-based H2O Asset Management, which is partly owned by French investment bank Natixis SA, saw £7 billion of customer withdrawals after an FT report revealed the firm had poured around £1 billion into illiquid bonds connected to Lars Windhorst, a German financier with checkered history. That, in turn, prompted fund-research adviser Morningstar to suspend its ratings on one of the funds.

As the Bank of England notes, “multiple recent episodes across a range of markets have further illustrated liquidity mismatch in some open‑ended funds”:

  • In December 2018, there was the mass withdrawal of $37 billion from open‑ended leveraged loan funds as herds of panicked investors responded to falling leveraged loan prices.
  • In June 2016, in the aftermath of the Brexit vote, six commercial real estate (CRE) funds suspended redemptions and nine funds adjusted the prices that redeeming investors could receive in order to account for the pervading uncertainty and wild swings in asset prices.
  • In late 2018 and early 2019, UK CRE funds suffered a fresh wave of redemptions , also due in part to uncertainty surrounding Bexit.

All of these episodes, while not large enough to pose a systemic risk, serve as a reminder that a significant mismatch in funds is “a vulnerability that goes beyond any single market or fund type.” And the more that funds stray into less liquid assets, in a desperate hunt for returns, the greater the threat this vulnerability could pose to financial stability. By Nick Corbishley, for WOLF STREET.

Shares of another equity fund plunged 22% suddenly. Other funds under pressure, raising serious questions about just how liquid “equity funds” in the UK are. Read…  Liquidity Fears Hit Other UK “Equity Funds” as Investors Remain Trapped in Woodford Fund


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