It's time for investors to face the truth about frozen funds

15 March 2010

Dominic McCormick explains why it is time to increase the heat on the frozen funds littering the mortgage, high yield, property and hedge fund sectors.

There is still a massive amount of denial in the industry regarding the estimated $20 billion in ‘frozen funds’ across the mortgage, high yield, property and hedge fund spectrum.

Eighteen months on from the epicentre of the global financial crisis (GFC) and more than two years from when the first funds were frozen, only a few have provided investors with a complete liquidity solution or even a clear roadmap by which a solution will be provided over time.

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On September 8, 2008, the Australian Financial Review carried an article titled “Redemption freezes a ‘short-term blip’” focusing on the various property/hybrid property and high-yield funds that had frozen redemptions in preceding months.

While this was before the collapse of Lehman in mid September of that year and the introduction of government deposit guarantees (and their affect on the mortgage fund industry), the sentiment of the article highlights the ongoing disconnect from reality that has been a feature of this issue.

Today, large elements of the financial services industry look on in bewilderment and are often too conflicted to more aggressively push financial institutions for proper solutions.

Regulators have tinkered at the edges but seem tied up with too many other issues.

Platforms and planners pay lip service to the need for solutions but are doing little to bring them about, and most (as with fund managers) continue to take full fees on assets their clients can do little about. One hopes that some planners and platforms are not too comfortable with the status quo despite the concerns of clients.

Indeed, investors are once again the big losers — paying significant fees to have large chunks of their portfolios locked up in illiquid assets, possibly for years, thereby reducing the flexibility to take advantage of other investment opportunities and to adopt an appropriate asset allocation in a challenging environment.

Still, there is no point dwelling on those advisers who, in hindsight, put too much into what have become illiquid funds.

While some clearly did not take liquidity into consideration adequately (or at all), the illiquidity problems that arose in 2008 were more widespread than even those who were expecting some liquidity problems (such as ourselves) had anticipated.

But that’s now history — the key is what is the industry doing about them? The sad fact for investors is not nearly enough.

In this regard the industry has to face some hard truths.

In most of these frozen product categories ‘normality’ is never coming back even after the government deposit guarantee expires.

The attitude of investors, planners, platforms and gatekeepers to liquidity has changed permanently, even if another liquidity crisis of the magnitude of 2008 is unlikely in our lifetimes.

In my mind, most of the affected funds with a predominantly retail unit holder base only really have two legitimate options — wind-up or undertake some form of secondary market listing.

Wind-ups may still take years in some cases, but at least it provides a roadmap that allows investors to plan.

Listing has mostly been put in the ‘too hard’ basket for now given fears the vehicles will trade at large discounts to net asset value (which they will), but it will be necessary in some cases if fund managers intend managing these assets on an ongoing basis.

Of course, I am not suggesting that solutions are easy or that most funds could be unfrozen and investors given money back tomorrow.

Further, there are significant differences between the various categories (and between funds within a category). At the more liquid end are fund of hedge funds (FoHFs) and some mortgage funds, while the less liquid end includes direct property and private debt.

Some FoHFs have therefore been much quicker to act and have already recommenced full redemptions (albeit often with extended redemption periods) or commenced/completed the wind-up of funds.

However, other prominent FoHFs remain largely frozen and are yet to provide a timetable for providing full liquidity. I suspect the reasons in some cases have little to do with the liquidity reality of hedge funds (which has improved markedly over the last year) and more to do with the commercial reality of trying to preserve funds under management and the associated fees.

In the mortgage space, Colonial has recently bitten the bullet and announced a decision to wind up two mortgage funds even though it may take as long as four years to do so. More are likely to follow.

In the truly illiquid classes like direct property the choices, in my view, are either to list on the Australian Securities

Exchange or some other secondary market or announce an orderly wind up.

The latter doesn’t have to be a fire sale of assets and may well take years, but at least investors have clarity over the end game.

In these areas, the industry needs to stop promoting the fantasy that things will return to normal (with ready liquidity) sometime in the near future.

Periodic redemption offers for a small fraction of a fund’s value (which are increasingly common) are, in my view, not a proper solution and arguably just accentuate the problem.

They drag out the uncertainty, create a ‘gaming’ culture as investors decide how to participate in the various offers and increase the risks that those investors who remain end up in a pool of the most illiquid and possibly poorest quality assets.

In practice, many of these periodic redemption offers are disguising what will effectively prove to be a slow, drawn out wind-up, without the clarity and certainty that an announced wind-up can bring.

Public listing is seen as too hard, especially for mortgage funds where investors have valued the perceived low risk that these ‘income’ vehicles have provided historically.

Still, some of the distressed funds may be candidates for such a listing (The Premium Income Fund previously run by MFS is now listed on the National Stock Exchange of Australia).

It seems inevitable that some of the property funds/assets will end up listed, especially when managers finally realise that a gradual wind-up is the only other reasonable alternative.

This appears to be a rerun of the outcome of the early 1990s unlisted property trust crisis.

In the meantime, managers continue to collect full fees on these assets, in some cases on net asset valuations that are somewhat questionable.

After all, if they were forced to provide immediate liquidity and sell assets, the valuations and fees are likely be lower.

But even if this is not the case, there is a legitimate question as to whether investors should be paying the same level of fees they were when the fund had daily liquidity.

While it is true that the small print always allowed the fund manager to suspend redemptions, most investors are today paying fees on something very different (and inferior) to what they thought (and were told) they were initially investing in.

An interesting example that has been highlighted lately is AMP’s Enhanced Yield Fund, which invests a large proportion of its assets into the Structured High Yield Fund.

This is a product that should probably not have been offered to retail investors with daily liquidity. Valuing the bulk of the underlying assets at cash plus accrued interest was a sure recipe for a huge liquidity mismatch and potential unit holder inequities when the GFC (or even a much milder version of it) hit.

AMP needs to be proactive in setting out a plan to resolve the situation here.

Unless it is prepared to buy the underlying assets at current valuations itself or through some of its own funds (unlikely to please AMP shareholders and/or policyholders respectively), a gradual wind-up or a listing (in this case less likely) seem inevitable.

Resolving it may see some brand damage (and loss of fees), but it will be better than dragging this situation out with the current uncertainty.

Why has there been so little pressure for solutions for these ‘frozen funds’? Is it still the ongoing shock of the GFC that allowed fund managers to get away with actions not tolerated in ‘normal’ times?

Is it just blind hope that things will return to ‘normal’ even though we now know things were anything but normal in 2006-07.

Once again, conflicts across our industry appear to be impeding greater scrutiny of this issue by the media, research houses, financial planners and even the industry bodies.

No wonder the reputation of this industry has been so badly hurt by the GFC.

Meanwhile, a number of vehicles are being set up by opportunistic firms to buy units in illiquid funds at a discount from investors.

Given the way managers are dragging their feet, more such vehicles are likely and, as well as an avenue for liquidity for desperate investors, they may well provide some excellent investment opportunities for those with patient capital.

From a longer-term portfolio construction perspective, it is important that investors don’t overreact to the current problems.

There remains a place for illiquid assets in clients’ portfolios and in some specialist managed funds.

However, investors should aim to ensure they are earning some form of illiquidity premium in terms of higher return when they are taking on that illiquidity themselves.

In the future, I see investors getting this exposure through the following mean:

  • Closed end, fixed term trusts and syndicates with very limited (if any) liquidity along the way. (But these should only be a small proportion of portfolios depending on timeframe and fees, and leverage and structure need to be looked at closely.)
  • As a small part of a diversified managed fund where the vast bulk of the portfolio (at least 80 to 90 per cent) is in liquid investments. This structure makes sense across more flexible diversified funds and specialist alternatives vehicles.
  • Via listed, traded vehicles that hold illiquid assets but provide varying levels of liquidity via a secondary market.

These structures allow investors to achieve some of the benefits of illiquid asset classes without excessive liquidity or structural risks to their portfolios.

In the case of listed vehicles, the price paid is vital to return outcomes as most of these vehicles will normally trade at a discount to the stated net asset value.

It needs to be accepted that in many cases investor losses that have been or will be made on the current crop of ‘frozen funds’ will never be recouped.

Coming up with liquidity solutions for investors will in most cases involve a loss of funds under management and fees for the industry.

Some of these solutions will still take years.

But investors need clarity about solutions, and this will go some way to addressing the level of distrust that this aspect of the GFC has generated. It is investors’ money. The past isn’t coming back.

The industry has to find solutions now that work for investors, not themselves.

Dominic McCormick is chief investment officer at Select Asset Management.

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