Bank of England to tighten redemption rules on open-ended funds
More protection is needed for investors at volatile times of the market, industry observers say
The current rules on redemptions for open-ended funds are not tough enough and the Bank of England is likely to intervene further to protect investors, industry observers say.
In its Financial Stability Report December 2019, published on December 16 2019, the Bank of England expressed concern that by offering daily redemptions while investing in illiquid assets, funds created incentives for investors to redeem ahead of others.
“The fact that the Bank of England has included vulnerabilities of the open-ended fund market in its Financial Stability Report tells you just how seriously they are taking the issues that have dogged the asset management industry this year, firstly with the Woodford debacle and then with the M&G Property suspension this month,” said Ryan Hughes, head of active portfolios at investment platform AJ Bell.
Total assets managed by open-ended funds worldwide have more than doubled following the global financial crisis, to around $55trn (£42trn, €49trn). Globally, more than $30trn of assets are now held in open-ended funds that offer short-term redemptions while investing in longer-dated and potentially illiquid assets, such as corporate bonds, the report says.
However, the AIC, which represents investment companies, said it was "not convinced that using pricing adjustments to manage the flow of redemptions will work".
The Bank of England acknowledges that open-ended funds play an important and increasing role in the provision of finance, both globally and in the UK. Open-ended funds are collective investment vehicles that can create units and sell them directly to investors.
“Ever since Mark Carney made his ‘built on a lie’ comment regarding liquidity mismatches in open-ended funds, the BoE was likely to step in to force change in the asset management industry,” Mr Hughes said.
“The proposals set out by the BoE and the FCA make it clear that the current rules are not tough enough and that further measures are required to ensure that fund liquidity does not become a systemic risk,” he added. “This is despite the fact that the FCA only proposed tougher rules for certain types of funds in September this year.
“The proposals could be interpreted that the use of daily trading for illiquid assets may be coming to an end. In addition, we may see more frequent use of ‘market value adjustments’ where the price of funds are manually marked down for those wanting to redeem to reflect the true value of the underlying assets.”
He said the FCA will now look to incorporate the proposals from the Stability Report into new rules that will be issued in 2020.
The Bank of England report said that at present the investment structure creates an incentive to redeem ahead of others, particularly in times of market stress.
When investors exit an open-ended fund, the fund pays them the unit’s price, which is based on the fund’s net asset value (NAV). In contrast, in a closed-ended fund, investors generally sell their interests to other investors in the secondary market, for their market value, which can be at a discount or premium to the fund’s NAV.
Investors may assess that they could benefit by redeeming early if they anticipate the fund may use the most liquid part of the portfolio to pay redeeming investors, the report says. This behaviour could be accentuated if the fund holds assets that are difficult to value because they are traded infrequently in illiquid markets, such as commercial real estate.
Ian Sayers, Chief Executive of the Association of Investment Companies (AIC), said that the risks posed by open-ended funds that hold illiquid assets have once again been laid bare in the Bank of England’s Financial Stability Report.
The report acknowledges that the structure could create systemic risks as well as leading to unfair outcomes for investors, he said.
“The Bank of England’s report suggests that a combination of longer redemption periods and discounted prices for investors leaving the fund could be used to reduce systemic risks.
"However, we are not convinced that using pricing adjustments to manage the flow of redemptions will work," he said. "It would also be extremely confusing for consumers."
If the discount that is applied increases at times of market stress, investors will still be incentivised to leave the fund earlier, before these pressures become acute, he said.
This "first mover advantage" is a primary cause of systemic risk and needs to be eliminated.
“These problems could be avoided by our proposal for ‘reliable redemption’, where the redemption terms of open-ended funds are fixed at the outset and matched to the time it would take to sell the assets in an orderly market. This would be much simpler to convey to investors and does not penalise them simply for wanting to leave the fund. It also avoids flooding a weak market with assets at low prices and protects against systemic risks.”
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