When you fail to read the question properly in the Exam – AF4 April 2019 Question 1(C)

 

Rule #1 – Don’t get caught short

‘It’s okay to invest because I can always get my money back if I want it’. Or so the theory goes.

It’s a generally accepted rule in financial planning that anyone committing to a market-linked investment should generally be prepared to do so for at least a five year period. However, the general expectation is that in the event of emergency, you can get at your funds.

The recent events surrounding Neil Woodford and Woodford Asset Management have highlighted that this may not always be strictly true. As most of you will know, Woodford’s flagship Equity Income Fund was closed for redemptions in June following a crisis of confidence which caused investors to start withdrawing their cash.

Mr Woodford’s relatively heavy weighting towards unlisted shares and other less liquid assets therefore caused a liquidity crisis, resulting in a halt on redemptions which at the time of writing had yet to be lifted. Analysis has indicated that up to half of the value of the fund was invested in illiquid assets.

April 2019 AF4 paper- Question 1(C)

The CII, when it wrote question 1(c) of the April 2019 AF4 paper, probably would not have envisaged that this would become quite so topical, quite so quickly. The question required you to state four ways that, firstly an open ended and secondly a closed ended fund could respond to a liquidity crisis following a substantial number of redemption requests.

Open ended funds

So open ended funds first (ala Mr Woodford). The first suggestion on the model answer was an exit penalty or dilution levy. The former is self-explanatory. The latter is a charge which reflects the fact that unusually high levels of buying and selling may increase the fund’s dealing costs and affect the value of its assets. Therefore, in order to protect the interests of existing investors, a charge is levied which may typically be 0.5% – 2.5% of the value of the trade to ensure the value of their holdings is not ‘diluted’ by the excessive dealing.

Swing pricing is a similar concept, whereby in the event of number of redemptions over a pre-defined threshold within a certain period, a minor adjustment is applied to the bid price. Similarly the manager could widen the bid-offer spread, or implement fair value pricing. FVP occurs where a security’s price is adjusted to an estimated current value if the most recently traded price is considered out of date or stale. This occurs at security level, whilst swing pricing occurs at fund level.

The fund manager could borrow to fund redemptions, which would bring temporary liquidity, albeit the loan would need to be repaid and would incur interest charges. Redemptions could be limited or, as per Mr Woodford, suspended altogether. Dealing periods could also be limited, meaning that the opportunity to redeem arises less frequently. The final answer would be forced sale for funds which invest heavily in property. The downside to this is obvious, forced sale usually means a bad deal!

Closed ended funds

Onto closed ended funds. The first thing to note is that this appears to be referring more to hedge fund type investments or unlisted REITs rather than market linked investment trusts. With a market linked investment trust, you don’t get shares being created and redeemed on a regular basis and redemptions aren’t funded by selling scheme assets. These are like any other company shares, they are traded on a regulated market at a bid and an offer price and can trade at a premium or discount to net asset value. And a lot of them tend to have more restricted dealing and redemption conditions in any event.

Closed ended funds can also borrow. They can also suspend dealing, they can also sell property. Because a lot of them are companies in their own right, they can undertake a rights issue, which is effectively creating new shares and expanding the market capitalisation of the business. The new funds could be used to fund the current redemption requests rather than touching the existing investments. Admittedly, this would have to be done pretty quickly! In addition, the shares could be moved to a discount, which means that they are trading below net asset value, or alternatively, the bid-offer spread could be widened.

Conclusion

The exam guide for April 2019 indicated that on the whole, this was not answered particularly well. It is worth spending some time ensuring that you understand and are comfortable with the basic concepts.

Mediocre previous answers + topical nature = high chance of recurrence in my experience!

Revision help

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