On Monday, the UK Financial Conduct Authority (FCA) announced proposals to tighten regulations surrounding open-ended funds invested in illiquid assets.
It follows concerns about the suspension of trading in several open-ended property funds following the UK’s vote to leave the European Union in 2016. Open-ended commercial property and infrastructure funds will be required to suspend trading when an independent valuer expresses “material uncertainty” about the valuation of 20% of their assets under proposed new rules published on Monday.
Domino effect for multi-asset funds
AJ Bell head of active portfolios Ryan Hughes said: “There is a risk that if a multi-asset fund has exposure to these illiquid areas then it would have to suspend so there is a domino risk in this”.
A fifth of portfolio holdings is a low threshold for a property or infrastructure fund to automatically shutter although stress events are likely to happen at the margin, says Hughes. The global financial crisis and the Brexit vote are the two times in his career that he’s seen property funds have to suspend.
“It’s still an unlikely event but that lowering to the 20% threshold would on balance make it more likely suspension would happen or it would certainty happen faster,” he said.
Under the FCA changes, funds would likely suspend during the early stages of any stress event and gating would happen simultaneously, he says. That’s not what happened during the aftermath of the Brexit referendum.
“A lot of property funds suspended in the end but it was almost like they were trying to cling on to see who could be last,” he said.
Post-Brexit property allocations fall
Currently, Architas Diversified Real Assets is the only Investment Association mixed asset fund with more than a fifth of its portfolio in property, according to FE Analytics. It holds 22.1%.
“Pre-Brexit you might well have found more funds with that allocation,” says Hughes, who said many mixed asset funds have reduced their property allocation following the raft of large open-ended funds that suspended trading in the aftermath of the referendum to leave the European Union. AJ Bell does not hold property in its active managed portfolio service (MPS).
Scottish Widows Balanced Growth and Janus Henderson Multi-Asset Absolute Return are the funds with the next highest allocations, holding 17.34% and 16.34% respectively.
IA mixed asset funds with the highest allocation to property
|Architas – Diversified Real Assets||22.1%|
|Scottish Widows – Balanced Growth||17.34%|
|Janus Henderson – Multi-Asset Absolute Return||16.34%|
|FP – New Horizon Growth||14.99%|
|Fidelity – Multi Asset Defensive||14.3%|
|Barclays – MA Adventurous Growth||14.16%|
|Fidelity – Multi Asset Growth||14%|
|Scottish Widows – Progressive Growth||13.96%|
|LF – Miton Worldwide Opportunities||13.43%|
|Scottish Widows – Discovery Solution||13.27%|
Source: FE Analytics
Ucits-qualifying funds best prepared for changes
The FCA said it was specifically aiming to reduce risks for retail investors in non‑Ucits retail schemes (Nurs) and that the proposed changes would have little impact on Ucits managers. Ucits are allowed to make limited investments in illiquid transferable securities but are not to invest directly in non‑financial assets like property or infrastructure.
Kames Diversified Monthly Income is the Ucits-qualifying fund with the highest exposure to property in the IA mixed asset sectors. It holds just 12.8% and is followed by the Capital Group Capital Income Builder with 12.4%.
Asset managers will likely return to using Ucits-qualifying structures for property funds, says Graham Bentley, managing director of investment consultancy GBI2. “The day of the 100% bricks-and-mortar fund may be over,” he says.
“Property funds’ retail sales substantially depend on being constituents of not only multi-asset funds but also DFM and advisory portfolios. Already, before the FCA paper, portfolio managers increasingly recognised that bricks-and-mortar property funds are riskier than their standard deviation numbers suggest, with maximum drawdowns some 10x the annualised monthly volatility – more than any other asset class.”
Ucits-qualifying IA mixed asset funds with largest property allocations
|Kames – Diversified Monthly Income||12.8|
|Capital Group – Capital Income Builder||12.4|
|Aberdeen – Diversified Income||6.64|
|VT – AJ Bell Passive Balanced||6.4|
|Amundi – SICAV II – Flexible Opportunities||6.29|
|Aberdeen Global – Diversified Growth||6.28|
|VT – AJ Bell Passive Moderately Cautious||6.21|
|VT – AJ Bell Passive Moderately Adventurous||6.1|
|VT – AJ Bell Passive Adventurous||5.94|
Source: FE Analytics
Bentley adds: “Multi-asset portfolio managers who have eschewed property, and have attracted the ire of some advisers as a result, will feel vindicated by the proposed changes, and more portfolio managers may similarly reduce holdings”.
Investment trusts should be the default for illiquid assets
The regulator has ignored the elephant in the room that open-ended funds are mismatched when it comes to illiquid asset classes like property, says the Association of Investment Companies.
“In contrast to the problems endured by open-ended property funds following the Brexit vote, closed-ended property funds continued trading, and no manager was forced to sell assets because investors sold shares. While discounts initially widened, they have now returned to previous levels.”
In the Morningstar Direct Property category investment trusts have outperformed over one, three, five and 10 years. In the 10 years to July 2017, closed-ended funds returned 79.7% on an net asset value basis and 203.4% on a share price basis, while open-ended funds returned 52.9% over the same period.
Quilter Investors head of investments Anthony Gillham says they use investment trusts where available because they are not subject to a run. He said it’s important customers have the security of knowing that they can get their money back if needed.
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