Illiquid assets

GLOBAL INVESTOR 1.15 — 25
Investors have many choices when selecting
a pooled investment fund: regional
versus global, active versus passive, bonds
versus equities, famous manager versus
start-up, and so on. But one choice can be
overlooked: open-end versus closed-end
funds. On occasion, this may be the most
important issue.
As we will show, the practical difference
for investment returns may not be great under
normal market conditions, but can become
significant at times of market stress, especially
for funds investing in illiquid assets such
as real estate, small caps, or specialized credits.
In such cases, a closed-end fund may be
the better structure.
Key differences
Closed-end funds have a fixed asset pool.
This can grow (or shrink) due to good (or bad)
investment performance, but normally no extra
capital is added from investors or paid out.
An existing investor who wants to exit must
sell on the open market to another investor
who wants to put money in. In contrast, the
assets in open-end funds can change because
of shifts in market prices as well as due
to net inflows or outflows of capital from investors.
When net new money comes in, the
manager invests in extra underlying assets,
while exiting investors sell units back to the
fund manager, who disposes of underlying
investments to meet net redemptions.
Operation under normal market conditions
Investors in open-end funds buy and sell units
at a level equal to the underlying asset value
(subject to enough liquidity, see below). By
contrast, the price of closed-end funds is typically
at a premium or discount to the underlying
assets, reflecting the balance between the supply
from exiting investors versus demand from
those entering. Academic studies have argued
that a premium might reflect the skill of the
manager or the rarity of the underlying assets,
while a discount might indicate lack of confidence
in the manager. Morningstar data shows
that, over the long term, closed-end US funds
have on average traded at a slight discount.
This tends to deepen when markets go down,
while it narrows or moves to a premium when
markets go up and investors become more
optimistic.
Some closed-end funds buy back their
own shares to try to narrow the discount, enhancing
value for remaining investors. Sometimes,
external predators try to gain control
and liquidate the fund at the market value,
thus effectively eliminating the discount.
Despite these measures, discounts and premiums
rarely disappear completely, perhaps
because demand for most closed-end funds
is dominated by retail investors who tend to
be procyclical.
When money flows in or out of open-end
funds, the dealing costs are in many cases
spread among all investors. The impact of these
costs may be negligible in large funds with
little movement, but can be a noticeable burden
on performance in small, fast-growing funds.
Perhaps, more importantly for an open-end
fund with specialist strategies in relatively illiquid
assets like small-cap or frontier-market
stocks, a good performance in the early years
when the fund is small may be difficult to replicate
later if large amounts of new money are
attracted by the good results, but are not easily
investible in the same way. So many successful
open-end fund managers in specialist
areas close their funds for new investments to
protect existing investors as they approach
capacity limits. If a manager does not do this,
there can be style drift, making the track record
of a fund manager less relevant.
Operation in stressed markets
When markets become stressed, such as during
the financial crisis, some assets may become
illiquid, while others remain easy to sell.
When this happens with an open-end fund,
the first investors to exit will tend to receive
cash obtained by the manager from sales of
the more liquid assets. While this is good for
these faster-moving investors, slower-moving
investors are left with units in an imbalanced
fund that holds mainly illiquid assets that cannot
be readily sold and for which the theoretical
valuation may fall further than the more
balanced portfolio existing before the stress
began. Well-known examples in recent years
include some frontier-market, real estate and
credit funds. Fund managers may have some
ability to restrict (“gate”) withdrawals. If this
is done early in the stress situation, it in effect
temporarily makes the fund closed, protecting
remaining investors. But in a worst-case scenario,
this closure happens after the faster
investors have left, which leaves remaining
investors trapped with a pool of illiquid underlying
assets that may then eventually be sold
as soon as some limited liquidity reappears,
which unfortunately is likely to be near the
bottom of the market.
Clearly, this process simply cannot happen
in a closed-end fund. Faster investors who
try to exit will likely find few buyers, forcing
the fund price down to a substantial discount
to the apparent net asset value. In the middle
of the financial crisis in early 2009, the average
discount of the largest US-listed closedend
funds rose as high as 25%. But the fund
manager is not forced into selling the underlying
assets to meet withdrawals. Investors
who are prepared to hold their nerve through
the phase of stress will still own a share in
the balanced pool of assets selected by the
manager, with a good chance of recovery after
the stress has passed, and they will not
be forcibly liquidated near the bottom of the
market by the selling actions of other investors
in the fund. Indeed, after the financial crisis,
the average discount narrowed quickly as
markets recovered, providing an additional
return driver for these funds on top of the rise
in price of the underlying assets.
Conclusion: Horses for courses
The conclusion is that investors should choose
between open-end and closed-end funds
largely on the basis of the underlying asset
type. For investments in mainstream, liquid
markets like developed economy large-cap
equities, an established large open-end fund
is probably the better choice in most cases.
It avoids the fluctuating premiums/discounts
of closed-end funds and should be large
enough to avoid issues of dealing cost attribution,
although it would likely not have leverage
capability.
In contrast, closed-end funds are likely to
be the better choice for underlying assets
such as real estate, frontier markets, small
caps and low-grade credit, since these are,
or are at risk of becoming, illiquid with all the
potential issues described above (see article
on Swiss real estate funds on page 47 for
more details).
Giles Keating
Head of Research and
Deputy Global Chief Investment Officer
+41 44 332 22 33
giles.keating@credit-suisse.com
Lars Kalbreier
Head of Mutual Funds & ETFs
+41 44 333 23 94
lars.kalbreier@credit-suisse.com