The mass shuttering of open-end mutual funds, a problem that has dogged the UK’s fund industry for months, appears to have crossed over to multiple fund industries in mainland Europe. According to Fitch Ratings, “at least” 76 European mutual funds, with an estimated $35 billion of assets under management (AUM), suspended redemptions in March after investors scrambled for the exits. Almost £9 billion was pulled from UK-based funds alone, more than any other month on record.
Fitch was able to identify the gated funds by scrutinizing their respective investment managers’ disclosures. But the actual scale of the problem is likely to be a lot larger than the numbers suggest. “The true extent of gating is even greater given that funds’ public disclosures are limited,” Fitch said. According to the European Securities and Markets Authority, funds totaling €100 billion in AUM suspended redemptions or applied other extraordinary liquidity measures in March.
Here’s a breakdown (by fund manager location, fund domicile and fund type) of the 76 gated funds identified by Fitch
Fund manager location: Almost two-thirds of the funds (53) were managed in Denmark. Fifteen were managed in the UK, five in Sweden and one a-piece in Finland, Norway and France. The preponderance of Scandinavian countries in the sample may reflect higher disclosure standards for fund managers in the region, Fitch says. In other words, other parts of Europe may also have growing numbers of gated funds that just haven’t been publicly disclosed yet.
Fund domicile, Luxembourg accounted for almost half (36 out of 76) of the gatings, reflecting the country’s dominant position as a domicile for mutual funds. The UK and Denmark respectively boasted 17 and 16 domiciled funds, while Sweden (5), Finland (1) and Norway (1) accounted for the rest.
Types of the gated funds:
15 funds, all UK-based, were in commercial real estate (AUM of €23 billion);
30 funds were in fixed income (AUM: €10.5 billion);
23 gated funds were equity funds (AUM: €1.4 billion);
5 funds were mixed funds (AUM: €1.9 billion).
Don’t Mention the “L” Word
“Widespread gatings like this are rare and the only comparable examples were during the 2008 financial crisis and following the 2016 Brexit vote,” Fitch said.
In the aftermath of the Brexit vote, six commercial real estate (CRE) funds gated. This time round, 15 CRE funds have so far shut their doors. Most of these were retail funds that offered daily redemptions though a few, such as the £3.4 billion BlackRock UK Property, were aimed at larger institutional clients and offered only monthly or quarterly redemptions. Combined, the gated funds account for roughly two thirds of all assets under management in the UK open-end property fund industry.
The official reason cited for the shuttering of these funds is that it is currently impossible to accurately value the funds’ real estate assets amid the market mayhem being caused by the response to Covid-19. Many of the open-end funds also probably suffered serious liquidity problems after sustaining significant outflows of investor money. They just don’t want to admit as much. As Fitch says, “even if the daily-dealing funds that gated recently had managed to avoid valuation issues, they would have had to gate anyway to prevent a surge in outflows.”
A sudden surge in outflows can be fatal for an open-end mutual fund, especially one with illiquid assets. When investors take their money out, the fund has to use up its remaining cash and then has to sell assets in the portfolio to raise money to meet the redemptions. In the case of commercial real estate, those assets can take months or even longer to sell, particularly in a downturn. This gives rise to that infamous “mismatch in liquidity” between what the fund offers to its investors (daily liquidity) and what the fund holds (largely illiquid assets).
Eventually, the fund runs out of cash and has no choice but to close its doors, leaving investors trapped and having to contemplate heavy losses. This is what happened to investors of M&G Investments’ £2.5 billion direct property fund, which gated in December 2019 after reporting “unusually high and sustained outflows.”
Rising Contagion Risk
Now, four months on, as more and more funds are following in M&G’s footsteps and shutting their doors, no one is talking about “outflows of funds” or “liquidity issues”, for one obvious reason: contagion risk.
Most of the gated funds in Scandinavia have adopted the same line used by the UK funds, blaming their decision to suspend redemptions on acute valuation problems. “The vast majority of gatings were driven by issues in pricing underlying securities across asset classes,” says Fitch. “There was even one case of an exchange-traded fund suspending trading due to pricing issues. Several funds have reopened but some are liquidating.”
In Europe, virtually all mutual funds operate with some degree of liquidity mismatch, with the vast majority offering investors daily liquidity with settlement within two or three days, notes Fitch. Some of those funds will have more cash and liquid assets on hand than others and will be better positioned to withstand heavy outflows. But as the recent saga involving the now-defunct £3.7 billion Woodford Equity Income Fund showed, even funds that claim to invest in highly liquid assets may be lying.
The good news, according to Fitch, is that the recent spate of fund gatings in Europe “does not pose an immediate threat to the broader financial system”. The volume of funds that have so far gated is a drop in the bucket compared with European mutual funds’ total assets under management, which were equivalent to around €16 trillion at the end of 2019.
The bad news, according to Fitch, is that “the interconnectedness of the financial system means that fund gatings can spread, giving rise to contagion risk.” This echoes earlier warnings from the Bank of England’s Financial Policy Committee that the liquidity mismatches of open-end mutual funds “can create an incentive for investors to redeem when they expect others to do so.” If this dynamic snowballs, it “has the potential to become a systemic issue.”
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