Should you avoid investing in funds with unlisted stocks?

Jupiter Asset Management’s decision to stop investing in unlisted equities within open-ended funds has reignited the debate over retail investor exposure to private companies.

Jupiter chief executive Matt Beesley wrote to clients last week to notify them of the change, acknowledging that “sentiment towards holding unlisted assets in open-ended funds has changed” as the company sold its exposure to Starling Bank.

The move has been applauded by a number of fund platforms and industry analysts, some of whom argue that unlisted companies have “no place” within open-ended funds.

Others, however, believe that fund managers should have the flexibility to seize potentially lucrative opportunities by investing in small private companies.

Sheridan Admans, head of fund selection at TILLIT, described Jupiter’s decision as “a positive step for investors – although it has been overdue.”

He said: “Investors are in limbo and worried whether their money is likely to move in the same direction as investors in Woodford.

There is no place for unlisted shares in an open-ended fund. Investing in private and unlisted illiquid assets is best left to the experts of a specific closed-end fund.’

When an investor buys an open-end fund, they can issue unlimited new shares, priced daily at their net asset value, which are retired once sold back.

These types of funds, designed for everyday, retail investors, have liquidity controls that should allow investors to buy or sell shares without requiring the fund manager to sell investments to meet redemptions.

They differ from closed-end funds, or investment funds, which only issue a certain number of shares that can then be traded on an exchange. Like any other publicly traded stock, their value depends on supply and demand.

Open-ended funds can get into serious trouble when the size of investor withdrawals exceeds the fund’s liquidity or cash levels. Retail funds typically allocate 2 to 10 percent of cash, depending on their size and asset class, to avoid this.

Such “liquidity mismatch” has become a common occurrence among open-end real estate funds in recent years, with large swaths of funds forced to use emergency powers to suspend trading and slow the tide of withdrawals while portfolio managers take on the long-running task. take to sell real estate.

While the suspension is designed to protect value, investors are still left without access to their money, as happened in the real estate fund industry in the wake of the 2016 Brexit referendum and more frequently since.

But real estate is an inherently illiquid asset, so investors accept the risk involved to some degree. This is not the case with equity funds.

Publicly traded stocks are as liquid an asset as it gets to trade, although companies with large market caps and shareholder bases will have better liquidity than smaller peers.

Unlisted companies are illiquid because they are not traded on an exchange, so investing in the company is generally not possible for the average investor. Under the city’s rules, open-ended funds are allowed to invest up to 10 percent of their portfolio in unlisted stocks.

Jason Hollands, managing director at Bestinvest, said: “Historically, some open-end funds have had little exposure to private companies.

“This is usually where the company in question is expected to go public in the near future (12 to 18 months) and there is a potential to make decent returns by leading the way.”

Hollands explained that “come close” to the 10 percent cap on unlisted stocks is “rare and would be a source of concern” because “market conditions may change, potentially delaying a hoped-for IPO.”

Lessons from Woodford?

The collapse of Neil Woodford’s asset management empire in 2019 is an infamous example of what can happen when there is a liquidity mismatch within an equity fund.

During WEIF’s five years of existence, unlisted stocks became increasingly popular as low borrowing costs offered the opportunity for rapid growth. Since the rise in interest rates, however, private equity valuations have fallen sharply.

The Woodford Equity Income fund, which had assets in excess of £6.5bn at its peak, invested part of the portfolio in unlisted stocks which Mr Woodford believed would have incredible upside potential once they developed . These include the likes Atom Bank and the Now Listed Oxford Nanopore.

But as the once-successful manager’s performance deteriorated, investors began to raise their money in ever-increasing amounts, forcing Woodford to suspend the fund as he sold his holdings to raise enough money.

The fund never recovered, ultimately leading to the collapse of Woodford Investment Management, and thousands of investors are still out of money.

Hollands said, “The WEIF debacle was pretty much a case study of how things can go horribly wrong when an open-ended fund has high exposure to illiquid companies.

“I’ve never felt comfortable with open-ended funds investing in unlisted companies. This is not to say that there is no merit in having exposure to private companies, but a much more appropriate way to achieve this is through an investment trust or an investment company.

That’s because even when markets are in a downward spiral and investors start selling their stocks, a mutual fund manager won’t be forced into a forced sale of his portfolio to write checks to investors like their peers who hold OEICs or run unit trusts.

“Of course, the trust’s own shares may fall during such times and trade at a greater discount to their net asset value. But the actual portfolio can remain intact without the need for divestments.’

Nick Wood, head of fund research at Quilter Cheviot, added: “We generally do not invest in equity funds with unlisted holdings.

There are occasional minor exceptions to this if we are happy with the risk taken and the manager’s strategy, but in general the liquidity mismatch that unlisted positions entail means we usually stay away from them.

This is not to say that private markets don’t play a role in an investment portfolio – they can be a great way to access early stage companies with good growth prospects.

“However, we would prefer to get this unlisted exposure through mutual funds as these stocks are listed on the stock exchange and so are easier to trade if we choose to sell.”

New rules on the horizon

The magnitude of Woodford investor losses forced regulatory intervention. The Financial Conduct Authority has imposed new liquidity management and disclosure requirements and is currently finalizing rules for setting up new fund structures, which could provide a more suitable vehicle for illiquid assets by restricting withdrawals.

But even with improved standards, many experts argue that an open-ended fund is never the right vehicle for investors to build exposure to privately held companies.

An Interactive Investor spokesperson said the trading platform has “consistently maintained that the closed-end investment trust structure is more appropriate for investing in illiquid assets because managers do not have to sell shares to meet redemptions.”

They added: “We’ve seen how devastating this can be in tough markets.”

The spokesperson said II does not believe the FCA should impose a full ban on open-ended funds investing in illiquid assets, but has encouraged the regulator to “consider whether current disclosure requirements around illiquid assets in open-ended funds go far enough ‘.

They added: “We would like to see more than a generic disclosure of how much the fund is allowed to invest.

“We also think the FCA should consider whether to apply redemption periods to funds that invest in illiquid stocks, not just real estate), to avoid overstating liquidity in a fund.”