Statement from Amati Global Investors on Liquidity in Open Ended Investment Funds
Analysis of TB Amati UK Smaller Companies Fund
Dr Paul Jourdan – 20 June 2019
The closure of the high profile Woodford Equity Income Fund has led investors more to check that the open-ended funds they own have adequate levels of liquidity. The demise of an open-ended fund through holding too many unquoted investments is not new in the fund management industry. In 1996 Peter Young caused furore at Morgan Grenfell Asset Management by holding unquoted investments which turned out to be three times the allowed maximum level. In 2008 there was a range of open-ended funds called Arch Cru which held only unlisted investments, but did so by packaging these investments up into cell companies listed on the Channel Islands Stock Exchange. These funds imploded in March 2009 catching 20,000 investors in the scandal, as it turned out that the unquoted investments were worth nothing like the values quoted by the manager. The positions took years to unwind, and the returns to investors were very small. The key message from all of this is that open-ended funds are not designed for holding investments in private companies. In our view it should be regarded as an anomaly that the UCITS legislation allows them to do so (with the exception of cases where a public company is de-listed, in which case a manager would end up with a holding in a private company inadvertently).
Therefore, we can say categorically that the TB Amati UK Smaller Companies Fund has no holdings in private companies, and will never choose to do so. This kind of fund is designed to hold quoted investments.
This leaves the question of "illiquid holdings". Unfortunately holdings in private companies are sometimes lumped together with some low-liquidity quoted holdings and are called "illiquid". This is misleading. Private companies tend to have legally binding restrictions around liquidity. Holdings tend to be sold when the whole company is either sold or listed. There can of course be secondary transactions in private companies, where an existing investor sells their shares, but these are strictly controlled events and require bespoke legal agreements in order to take place. Such holdings cannot be said to be liquid in any sense and should be called "locked-up" so that they are not confused with securities which simply have low levels of liquidity in terms of numbers of shares traded every day. Investments in private companies which are loss making are doubly problematic because in these cases, if a holder wants to sell to a new investor (a "secondary sale") they are competing with the company itself, which may be wanting to issue new shares to raise further cash for the business, and so the company has an incentive to block the secondary sale.
"Illiquid" or "low liquidity", in our book, refers to stocks which are quoted on major stock markets (AIM or main market of the LSE in the UK) but which don't have high levels of turnover. In other words, they have the possibility of liquidity on any day without any special agreements being sought, even if such liquidity is not always available.
The problem with measuring the liquidity of quoted companies is that it is never clear whether the lack of turnover is limited by the absence of buyers or sellers, or both. If there are lots of sellers, but no buyers, then the stock is liquid for buyers but not sellers, and vice versa. There are no published numbers in which this shows up. Equally, for most businesses worth in excess of £50m quoted in London there is a price at which liquidity can be achieved on any day by offering to trade at a price outside of the quoted spread, but the extent to which this varies from the quoted price is impossible to determine in advance, and will always depend on the urgency required.
We regard the TB Amati UK Smaller Companies Fund as having high levels of liquidity. All securities are quoted in London, and that the weighted average market capitalisation of the holdings is around £880m. We also monitor the average daily turnover of stocks in the portfolio and the amount of time it would normally take to liquidate positions in the fund if we traded at that level each day. However, we regard these numbers with caution, as any one of the stocks we hold can trade much larger numbers than the daily average on occasions when there is a need to do so, whilst equally, in a market panic, liquidity for sellers declines steeply. We take comfort from the fact that where we had some holdings in common with Woodford Equity Income Fund, such as Watkin Jones, we saw the potential overhang of over 10% of the company cleared in two trading days, and we were amongst those who added to our holding.
To provide a further level of comfort to investors, we provide an analysis of liquidity in our fund using the methodology adopted by Andrew Bailey, Chief Executive of the FCA, in his response to questions from Nicky Morgan, Chair of the Treasury Committee. This shows that in his letter of 18 June 2019 he provides a breakdown of liquidity within Woodford's Equity Income Fund in the following buckets, as analysed by Link Fund solutions. Each bucket contains the proportion of the securities that can be sold within a specified time period. The analysis ignores any cash holdings.
|30 June 2018
Woodford Equity Income Fund*
|30 April 2019
Woodford Equity Income Fund*
|13 June 2019
TB Amati UK Smaller Companies Fund**
|Bucket 1 (1-7 days)||21%||8%||59%|
|Bucket 2 (8-30 days)||24%||29%||36%|
|Bucket 3 (31-180 days)||30%||32%||4%|
|Bucket 4 (181-365+days)||25%||33%||1%|
** Source: FactSet and Amati Global Investors
We would argue that the analysis of the Woodford Equity Income Fund here is insufficient in regard to "Bucket 4", as it doesn't distinguish between "illiquid" and "locked up" (i.e.: investments in private companies) as we suggest above. If the "locked up" category were split out, it would also advisable to divide it into two categories: 1) investments in profitable private companies, and 2) investments into loss making private companies, with the latter being regarded as much more difficult from a liquidity perspective because the sale is more likely to conflict with the company's interests.
For the sake of comparison we have put together an analysis of liquidity in the TB Amati UK Smaller Companies Fund. This is based on average volume of shares traded over six months to 13 June as reported by FactSet. We should note that these reported share volumes only reflect shares traded in the market and ignore those traded in the so-called "dark" pools, which means that we are potentially understating the liquidity actually available. The 5% which the TB Amati UK Smaller Companies Fund shows in Buckets 3 & 4 consists of companies which are either a) dual listed with fungible shares, so that the share volumes being counted are an incomplete picture of the actual liquidity, or b) recently floated, so the share volumes have not had much time to build up yet, our holding in the retailer Cake Box being an example, where we believe in practice we could liquidate such holdings in a shorter timeframe than this analysis suggests if we needed to. Importantly, the fund has no "locked in" holdings.
These figures show that our fund has ample liquidity based on historic share trading volumes as befits an open-ended structure. In the long run the best protection for any open ended fund is to make sure that it invests in high quality quoted businesses that are likely to be in demand from other investors if liquidity is needed. This exactly is what we put a great deal of work into achieving for this fund.