Open-ended funds that invest in inherently illiquid assets can encounter problems if too many investors try to withdraw their money at short notice at any one time. This happened when the United Kingdom voted for independence from the European Union on 23 June 2016, forcing some property funds to suspend dealing for the rest of the year.

The Financial Conduct Authority has now brought in rules to prevent such a thing from happening again. It hopes that its new measures will help investors in such a situation 'understand' why the funds are denying them access to their investments and the circumstances in which the FCA might allow the fund firms to pile on restrictions. A run on a fund can be devastating because it often reduces the value of the investments that the fund holds.

In the case of a fund that invests in immovables, the FCA wants to use the new rules to stop some investors from gaining at the expense of others because units have been incorrectly priced due to uncertainty about the value of assets that the fund holds.

In June the LF Woodford Equity Income Fund, fund of Undertakings For The Collective Investment Of Transferable Securities, suspended dealing. This, too, was a case of illiquid assets being held in open-ended funds. The new rules are not, however, aimed at UCITS funds such as Woodford.

Suspensions in both types of fund demonstrate the problems that open-ended funds experience when holding illiquid assets while also offering daily dealing. Had suspension not occurred, it would have been very difficult for the funds to treat the investors who remained in them equally and fairly when the problems with liquidity arose.

More onerous requirements

The FCA is at pains to stress that it does not want to prohibit open-ended funds from investing in illiquid assets as long as the investors are willing to run the liquidity-related risks this can involve. In the new rules it introduces a new category of "funds investing in inherently illiquid assets"  into its rulebook. It makes it compulsory for a non-UCITS retail scheme to suspend its dealing in fund units if the standing independent valuer expresses material uncertainty regarding the value of 20% of the scheme property. After some reportedly brisk lobbying from the fund industry, the FCA has decided to allow an authorised fund manager to continue to deal if it has agreed with the fund’s depositary that this is in the fund investors’ best interests - a change from the status quo. The new rules will come into force on 30 September 2020.

The FCA is planting new rules in COLL [the Collective Investment Schemes part of its rulebook] 6.6.4BR and 6.6.4CR (and amendments to its 'guidance' in COLL 6.6.11G) to require depositaries of "funds investing in inherently illiquid assets" or FIIAs to assess the liquidity profile and liquidity risks presented by the fund’s scheme property regularly. In addition, it will require depositaries to devise procedures for overseeing the management of liquidity by the fund managers in question.

Liquidity buffers

The regulator has decided not to proceed with guidelines that limit the accumulation of large cash buffers in both UCITS and non-UCITS funds. This is its main departure from its original proposal.

The idea here was that funds should not accumulate cash, and cash-like investments, or hold them for long in anticipation of unusually high and unpredictable volumes of redemption requests. The FCA wanted to use the rule to ensure that fund managers met investors’ expectations. Large cash positions create a drag on yield and make funds perform poorly. This may disappoint investors who expect to be more exposed to the risks and rewards associated with a particular asset class. The regulator also wanted to dissuade investors from redeeming investments before other investors for fear that the fund will suspend dealing when its cash levels are depleted.