News & analysis
OPEN-ENDED ILLIQUID FUNDS COULD POSE “SYSTEMIC RISK” - REGULATORS
Daily redemption promises in open-ended funds invested in illiquid assets have the potential to become a systemic risk, the regulator and industry organisations have warned. Open-ended funds, which are investment vehicles that can cre- ate units and sell them directly to investors, have caught the eye of various regulators in the wake of the Woodford scandal and M&G suspending its property fund. In its most recent financial stability report, the Financial Con- duct Authority (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 attempted to mitigate this at the end of 2019 by intro- ducing 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 hav- ing 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 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 redemptions for open-ended funds, whereby redemption terms of the fund should be matched to the liquid- ity 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 dou- bled 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.
DEFINED BENEFIT SCHEMES SHIFT TO BONDS HIGHLIGHTS YIELD RISKS
Defined benefit (DB) schemes are continuing to shift asset allocation from equities to fixed income but investment risk remains a key concern, particularly for schemes with higher deficits, Pension Protection Fund (PPF) data has revealed. While the overall deficit in the PPF’s universe has declined to £160bn, from £188bn last year, partly due to the updated s179 valuation guidance, funding ratios of smaller schemes have declined. In the event of a further fall in gilt yields, this could leave schemes at risk of a double whammy of declining fund- ing ratios and falling returns. Stephen Wilcox, chief risk officer at the PPF, said: “While many schemes have reduced their investment risk, the num- ber of schemes in deficit is more than double what it was in 2006 and the economic circumstances much less favourable. The funding ratio of schemes in deficit is particularly vulnera- ble to economic shock. “Although the PPF is much better equipped to manage that risk than we have ever been – our own funding ratio is stable, we have years of experience under our belt and we have a healthy reserve to fund future claims – the potential claims of underfunded schemes pose a significant risk, which is beyond our control,” he warned.
8 | portfolio institutional February 2020 | issue 90
Of the remaining 5,422 DB schemes in the PPF’s universe, the average equity allocation fell to 24% from 27% while the pro- portion invested in bonds rose to 62.8% from 59%. In 2006 the proportion invested in bonds was 28%. This picture is supported by data from Aon’s annual Global Pension Risk Survey, which found that 40% of respondents anticipated further reductions in their equity allocations in the next 12 months.
Index-linked bonds made up the largest proportion of fixed income allocations by DB schemes at 46.2%, a figure little changed from the previous year, suggesting that investors con- tinue to anticipate an uptake in inflation. This is despite the fact that the latest Office for National Statistics data shows a decline in CPI inflation to 1.4% in January, down from 1.8% 12 months earlier. Meanwhile, 28.4% of schemes were invested in corporate bonds and just over a quarter were in government issued fixed- interest bonds.
The PPF said that smaller schemes were more likely to have higher proportions in government and fixed interest bonds than index-linked bonds. Within equities, the UK-quoted proportion fell to 16.6% from 18.6%, while exposure to overseas-quoted and unquoted/pri- vate equities increased slightly to 69.7% and 13.7%, respectively.
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