Daily redemption promises in open-ended funds invested in illiquid assets have the potential to become a systemic risk, the Financial Conduct Authority (FCA) and industry organisations have warned.
Open-ended funds, investment vehicles that can create units and sell them directly to investors, have caught the eye of various regulators in the wake of the Woodford scandal and M&G’s Property fund suspension.
In its most recent financial stability report, the FCA and the Bank of England warned that the combination of generous redemption terms inherent to open-ended funds and the illiquidity of the underlying assets could trigger forced asset sales in the event of market stress.
With some $30trn (£23trn) globally invested in illiquid open-ended funds, 8% of which is in property, the regulator warned that this liquidity mismatch has the potential to constitute a systemic risk.
The FCA has attempted to mitigate at the end of 2019 by introducing tighter requirements for open ended property funds who are now expected to suspend trading if at least 20% of the value of their assets are at risk.
Briefly after the introduction of the new rules, M&G suspended its property fund in December, having faced significant outflows. The fund is still suspended at the time of writing, despite having raised more than £70m through asset sales in the past month.
Illiquid open-ended funds have also drawn criticism from industry group the Association of Investment Companies (AIC), which in a recent report described the liquidity, mismatch as a “square peg in a round hole”.
The AIC, which represents the interests of the investment trust industry, has called on the regulator to introduce a system of reliable redemption for open-ended funds, whereby redemption terms of the fund should be matched to the liquidity of the underlying asset.
Fund managers should not rely on selling assets at a discount and redemption terms should be suitable for a normal and stressed market environment, the AIC said.
Total assets invested in open-ended funds have more than doubled since the outbreak of the financial crisis, from more than $20trn (£15.3trn) in 2006 to $55trn (£42.3trn) by the end of 2019, the FCA revealed.
While the regulator says it is committed to introducing tighter rules, a key challenge it will face is the global nature of the open-ended fund industry. Around two thirds of UK assets in open-ended funds are held outside of the UK’s jurisdiction. Simultaneously, half of UK fixed-income fund assets are foreign assets, FCA data revealed.