“We regard liquidity mismatches as a major structural flaw.”
By Nick Corbishley, for WOLF STREET:
Two Irish commercial real-estate mutual funds, with a combined value of around €1.4 billion, have blocked redemptions after sustaining heavy outflows, leaving thousands of investors twisting in the wind. This has stoked fears that the liquidity issues that have dogged the UK’s mutual fund industry over the past year, beginning with the high profile gating of the £3.7 billion Woodford Equity Income fund (WEI), have now spread to another European economy. According to U.S. ratings agency, Fitch, contagion is now a very real danger.
Both of the gated funds were “open ended,” meaning they offered investors daily liquidity. When large numbers of investors began taking advantage of this facility by taking their money out, the funds had to sell assets in the portfolio to raise enough money to meet the withdrawals. This is not a problem when the assets in question are highly liquid, such as large-cap stocks. But when the assets are commercial real estate that can take weeks or more likely months to sell, there is a mismatch in liquidity between what the fund offers to its investors (daily liquidity) and what the fund holds (largely illiquid assets).
This is a big risk with these types of open-end mutual funds. And that risk could be about to grow, warns Fitch:
We regard liquidity mismatches as a major structural flaw that is likely to become more evident if the European CRE sector, or investor sentiment towards it, weakens. There is also the risk of contagion. If a fund experiences a spate of outflows, investors in other funds invested in similar assets may move fast to redeem their holdings to limit exposure to declining asset values after forced sales. If a fund is gated, the publicity may increase this contagion effect, while also potentially causing wider reputational damage to the investment manager and the sector.
Ireland’s commercial real estate market has bounced back impressively from the last crisis. But concerns have been rising that the boom is running out of steam, partly due to the mammoth troubles of WeWork, which, which after its scuttled IPO and subsequent write-down and bailout by SoftBank, pulled out of two big Dublin property deals in October. Since then, a number of property funds – including funds managed by Irish Life, Zurich Life Assurance and Aviva – have cut the value of their portfolios after being hit by a surge in redemptions.
But even that wasn’t enough. Last week, the Irish Property Fund and Friends First Irish Commercial Property Fund, both owned by the British insurer Aviva, announced they were freezing withdrawals for up to six months after failing to meet investors’ demands for the return of their cash. The funds, whose properties include the Royal Hibernian Way shopping mall in Dublin and the Globe Retail Park in Naas, have already been marked down by 7% and 9.1%, respectively.
Contagion already appears to be spreading across parts of the UK fund industry following the gating last year of WEI and M&G Property Portfolio. Once worth £10 billion, WEI was closed for good in October, leaving more than 300,000 (largely retail) investors shouldering losses of up to 50% of their initial funds. As for M&G Property Portfolio, it closed its doors in December after investors yanked an estimated £900 million from the fund in the first ten months of 2019. The fund remains shut today as it tries to raise cash by selling some of its assets.
Property funds endured the largest and most sustained withdrawals on record in 2019, with total outflows of £2.2 billion — the equivalent of £1 in every £15 under management — according to global fund transactions network Calastone. The intensity of outflows grew over the course of the year, reaching a crescendo in the final quarter when £770 million of funds were withdrawn.
By contrast, UK equity funds saw record inflows in December of almost £2 billion in response to Boris Johnson’s electoral triumph, marking a positive end to a year scarred by the fall of once-legendary stock-picker Neil Woodford. But concerns remain about the pace of recent outflows from Invesco’s UK-focused funds, which were, ironically, managed, with incredible success, by Neil Woodford until 2013, when he left the U.S. firm to set up his own investment company, taking many of his Invesco clients with him.
Over the past three years, the combined value of the three funds has plunged from £16 billion to £8.5 billion. In the final quarter of 2019 the three funds suffered outflows of just over £1 billion — its biggest three-month redemption since September 2014, just after Mark Barnett took over Invesco’s Income and High Income funds from Neil Woodford.
Two of the funds were also hit by Morningstar downgrades over their exposure to smaller and illiquid companies. In another ominous portent, Zurich Insurance in January decided to block new investment into its £215 million ‘mirror’ Invesco Income and High Income funds citing liquidity concerns, just as it did with Woodford’s Equity Income Fund little more than a month before it was gated.
The reverberations could extend beyond the industry: “Banks or other lenders may also be affected if an affected fund uses them for debt financing or liquidity facilities,” Fitch warns. “However, significant contagion to the broader financial system is unlikely given CRE (commercial real estate) funds’ small relative size. CRE funds represent only about 2% of mutual funds globally by assets under management.”
But it’s not just CRE funds that are managed on an open-end basis. So, too, are many equity funds with illiquid assets, such as shares that are not publicly traded or are only thinly traded — which is what Woodford’s fund tripped over — and even some hedge funds. And these funds account for a much larger share of assets under management. And some of those funds, as investors have recently learnt in the most costly of manners, may have less liquid assets than they’re supposed to.