Locking the Mutual Funds door because of uncertainty Wednesday, March 12, 2008
Back in June, before the credit crunch took hold, I was talking with CIO of one of London's leading Fund of Hedge Fund firms about the issues I saw with hedge fund investors only being able to trade back with the manager. Specifically when you only have one counterparty with whom to trade, that counterparty can control the price, the terms of trade or simply refuse to trade. He dismissed these as theoretical problems, pointing out they had no problems redeeming funds whenever they choose.
Obviously 6 months on and the experience of many investors is very different. Many bond and property funds have suspended redemptions leaving investors unable to sell and exit their investment. Such suspensions have often been attributable to the inability of the fund to quickly realise sufficient cash to meet withdrawal requests either because they cannot find buyers or the price at which they would be forced to sell would be materially damaging to remaining investors in the funds.
However, another scenario exists which is cited by ING in suspending redemptions in two funds yesterday was that they couldn't price the fund in the absence of reliable market prices i.e. when no one is trading, there is no reference price for you to value fund holdings and thereby arrive at a "share/unit" price for the fund. Whilst a "guess" could be made of holding value, a price that was subsequently shown to be materially wrong would either affect the sellers or remaining investors and potentially open the managers to litigation.
A simple example to illustrate this:
- A fund has 1,000 shares in issue and owns one bond which had been valued at £500 plus cash of £500. As such each share is worth £1. There are two investors in the fund each with 500 shares.
- In the absence of trading, the fund cannot find a reliable price to value the bond and so it guesses the price is still £500, being the most recent price it could find.
- One of the investors asks to redeem its shares. The calculated value of the fund is still £1,000 and so the price is therefore calculated at £1 [for simplicity I am ignoring accrued income/charges and other factors affecting value/price]. The exiting investor receives £500 in cash and the fund now only holds a bond.
- The next day a trade in the market determines that the value of the bond has actually fallen to £250. Had this been reflected in the previous day's valuation, the fund would have only been worth £750 and the exiting investor would have received £375 for their shares. The remaining investor complains that they are suffering a loss of £125 that actually should have been borne by the exiting investor and sues the manager.
Leaving aside current market conditions, a similar situation could have historically arisen when a large fund investor wished to redeem. The prices achieved when quickly liquidating a large portfolio of assets to fund such a redemption are likely to be lower than trading small quantities - termed market impact, it is a reflection of few things including supply v demand conditions; the knowledge that there is a large "forced" seller; and the concern that the seller is exiting in a hurry because of something they "know". Consequently, a manager could impose a large redemption penalty [price = assumed fund value less a discount of say 25% to allow for market impact]. However, there may be such uncertainty about the prices that will be achieved that even a 25% discount may be insufficient and so it is considered safer to refuse to redeem. Alternatively, a manager could insist that the redemption be staged over an extended period to allow for an orderly wind down of a fund.