Economics and investment: the new liquidity trap

Why are open-ended investment funds allowed to promise daily dealing, when the assets they own can’t be sold this quickly?
July 18, 2019

Liquidity. It’s a fancy word for investors’ most basic instinct: to pull their money out when they like. It was this desire—and the inability of Woodford Investment Management (WIM) to satisfy it—that shattered the reputation of Neil Woodford, once the top name among Britain’s private investors.

Faced with an avalanche of requests to withdraw funds, on 3rd June WIM was forced to suspend redemptions, notably from its flagship Equity Income fund. This left £3.7bn stranded, with no indication how long the lock-up might last. Woodford had put a lot of investors’ money into assets he could not sell quickly when they asked for their money back, especially highly “illiquid” small companies not quoted on a stock market.

This is not the first time investors have seen funds suspend redemptions (known as “gating”). Several property funds were gated during the financial crisis. Again the problem was liquidity, then selling buildings fast enough to return investors’ cash.

So why, you might ask, are open-ended investment funds allowed to promise daily dealing—meaning you can pull your money out at any time—when the assets they own can’t be sold this quickly? The truth is everyone knows this vast contradiction can cause major problems, but most of the time it doesn’t and so they carry on riding their luck as if the issue didn’t exist.

Unfortunately, though, it does. And it causes plenty of headaches. For a start, it’s clear many private investors were shocked to find daily dealing did not mean they could get their money back on demand. The system also unjustly advantages those who pull out first. The manager will always sell the most liquid assets to meet these redemptions, leaving the fund concentrated in assets that are harder to sell, and those at the back of the queue with the worst quality and least saleable holdings.

The other problem is that liquidity isn’t a constant. The same asset, be it a share in a company or an office block, can be easy to sell in a good market and impossible in a bad one. Unfortunately, it’s in the bad markets that most people want to sell.

It is not a good idea to lead people to believe that all their investments are liquid—even those that look that way today might look very different next week. Instead, investors should be obliged to give notice of withdrawals from all open-ended investment funds, five trading days perhaps in normal times, more during market stress. This would give managers more time to make orderly sales and it might also allow time for investors who have panicked to calm down—even change their minds.

Fund managers won’t like this because it may discourage investment in the first place. None of them can promise instant liquidity under all circumstances. Not even those who are highly diligent. We can’t persist with the illusion that assets meant to be held as long-term investments can be sold instantly any time we like. For experience repeatedly shows they cannot.