British fund manager Neil Woodford is seen in this undated handout image released July 18, 2019. Jonathan Atkins/Handout via REUTERS THIS IMAGE HAS BEEN SUPPLIED BY A THIRD PARTY.
Cautionary tale: The suspension of Neil Woodford’s Equity Income fund in June has provoked broader concerns © Reuters

The crisis surrounding Britain’s best-known stockpicker, Neil Woodford, has highlighted a concern individual investors had given very little regard to until now — the liquidity of their investment funds.

The ability to buy and sell funds daily was long established as an advantage of investing in mutual funds. Exchange traded funds were promoted as products that allowed investors even more flexibility, by offering multiple trades throughout the day.

But the suspension of Mr Woodford’s £3.5bn Equity Income fund last month has laid bare a problem that regulators had feared. Known as liquidity mismatch, it entails funds that offer daily dealing being unable to meet that promise because of the hard-to-sell nature of their underlying holdings.

Woodford Investment Management was forced to temporarily prevent trading — a process known as gating — on June 3. This was after it received a mass of redemption orders that it could not process due to its inability to sell the funds’ assets quick enough.

“The gating of the Woodford fund should be a wake-up call to all investors,” says Hector McNeil, co-chief executive of HANetf, an ETF company. “We have long argued that intraday liquidity is a huge advantage that ETFs offer over traditional funds — regardless of market conditions, an investor can trade in and out quickly and get their money back.

“Having paid significant fees for underperformance, Woodford’s investors are now having salt rubbed in their open wounds as they cannot get their money back to redeploy.”

He predicts that, because national regulators and investors are focused increasingly on value for money, the incident could prompt investors to switch out of mutual funds and into ETFs.

“We have argued that ETFs are a superior distribution technology because they offer transparency, liquidity and market access at low costs,” Mr McNeil adds.

“It is exactly these features that many Woodford investors now wish they had — the transparency to know about unlisted and illiquid securities risk and the liquidity to trade and exit at a time of their choice.”

But the scrutiny of investment fund liquidity has now spread to ETFs themselves because of their self-declared advantage of increased tradability. In July, the Bank of England’s Financial Policy Committee, along with the UK’s Financial Conduct Authority, produced its half-yearly report into financial stability, which included an analysis of the ETF market.

It identified two main risks that ETFs posed to financial stability. First, that certain products that invested in less liquid assets such as emerging markets and corporate bonds could create market stress, if investors in the products rushed for the exits at the same time.

Other regulators, including the Central Bank of Ireland and the International Organization of Securities Commissions, based in Madrid, have looked into the potential systemic problems posed by ETF liquidity mismatching.

However, the Bank of England conceded that this was not as big a problem as liquidity mismatches in mutual funds, because ETFs traded on a secondary market, so there would not be the same pressure on the underlying assets.

The second risk the Bank of England identified was that of a liquidity crunch in the entire ETF market. But the bank conceded this was a remote possibility as ETFs made up a relatively small part of certain key markets.

“The Financial Policy Committee has therefore judged that the majority of ETFs do not appear to present material financial stability risks, but will keep the risks in this sector under review as part of its regular annual assessment,” it wrote.

Though the Woodford crisis has brought additional scrutiny on the risk of liquidity mismatches, Mr McNeil says it is unlikely an ETF would have been caught by the same problems as the Equity Income fund.

“There has been much speculation in the press around ETFs and what would happen in times of volatile markets,” he says.

“It’s interesting that if such an event as has befallen Woodford had been in the ETF world, it would have been seen as catastrophic. ETFs almost universally have liquidity screens to prevent such events and investors should use this event as a wake-up call.”

The Bank of England is just one of several major authorities monitoring the potential systemic risks of ETFs. Last year the European Central Bank undertook its own study of liquidity and counterparty risks in the products. It looked at the potential for ETFs to contribute to periods of market stress.

In its response to the report, published in July, however, the European Fund and Asset Management Association (Efama), the lobby group, argued that some of the ECB’s findings were overdone.

“A key — but often overlooked — indicator to appreciate the resilience of ETF liquidity is the depth of its secondary market,” Efama wrote. “This acts as an additional ‘layer’ of liquidity when compared to ordinary mutual funds.

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“Evidence confirms that both for equity and fixed income ETFs, the secondary market has largely ‘cushioned’ the impact of sudden market shocks, without affecting investors’ ability to redeem their shares, nor that of dealers to trade the underlying securities.”

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