TheChek News Flow

‘Trash ratio’ can easily rise beyond intended limits if investors pull out of funds

A previously little-known feature of EU funds law has been attracting investors’ attention after a string of issues at GAM, Woodford, and now H2O Asset Management.

Such funds are all run under so-called Ucits (Undertakings for Collective Investment in Transferable Securities) rules. This European directive is designed to allow regulated, liquid funds to be sold to investors in Europe and, other than the US, worldwide. The range of assets they can invest in includes mainstream stocks or bonds.

However, one article in the directive states that funds can also invest in other, less liquid assets. It allows managers to hold up to 10 per cent of their funds in assets that in reality could prove hard to sell, and is known in the industry as the ‘trash ratio’.

Why is this a problem?

In the good times, it is not. 

When clients are putting money into a fund, then the manager can easily control the trash ratio, stopping it from exceeding that 10 per cent limit by using inflows to buy other more liquid assets or keeping them as cash. The trash ratio then shrinks as a proportion of the fund, unless the manager chooses to buy more illiquid assets.

This has been the case for most of the past decade. The Ucits industry has more than doubled in size since the financial crisis, to nearly €9.3tn in assets. Other than a fall during last year’s market sell-off, the sector has grown in size every calendar year since 2008. 

What happens if investors start to withdraw?

This is where it can get tricky. Such funds usually offer withdrawals on a daily basis. When, for whatever reason, clients want their cash back, managers tend to dispose of assets that are easier to sell, such as large-cap stocks or major government bonds that are easier to price.

But if a fund has been running a maximum 10 per cent in the trash ratio, then redemptions can quickly mean the proportion creeps higher as a share of the fund.

In that situation, the manager is not obliged to correct such a breach of the rules immediately. However, the manager can quickly land in a quandary, whereby investors who have exited have their cash back, whereas clients left in the fund have a higher share of harder-to-price assets. These assets could potentially not be worth as much as the manager had thought, or simply take a long time to sell. Either way, investors left in the fund could be disadvantaged.

GAM fell foul of this problem last summer, when it suspended star manager Tim Haywood and then quickly had to suspend and later liquidate his funds. Neil Woodford, too, had to suspend redemptions to stop illiquid assets becoming too big a share of his fund.

How widespread is this problem?

Tough to say.

Francesco Filia, chief executive of hedge fund Fasanara Capital, argues that 10 years of zero or negative interest rates and “heavy manipulation” of asset prices by central banks have forced “desperate” fund managers to bump up returns by adding illiquid, long-duration assets. He adds that this has been happening in funds’ trash ratios.

So far, individual cases have come to light during a bull market. The worry is that, during a bear market when clients are more likely to pull out their cash and liquidity can vanish, they may prove to have been the canaries in the coal mine.

Victory for New Democracy, the main centre-right party, could reignite volatility

Greek elections are around the corner. Investors should be optimistic but not complacent.

I believe New Democracy, the main centre-right party, will win the poll on July 7, with leader Kyriakos Mitsotakis becoming the next Greek prime minister. Yet, with current PM Alexis Tsipras in opposition, Mr Mitsotakis’s attempts for bold reforms will raise social tensions — something that Mr Tsipras had kept firmly under control.

It was a devastating fire at Mati, south of Athens, in late July last year that led Mr Tsipras to abort the national elections he was rumoured to be considering for September 2018. Polls would have been very timely as Greece had emerged from its third international bailout in August; domestic sentiment was positive after yet another record year of tourism; and his trips to London and Brussels had proved successful.

However, the destruction caused by the fire, exacerbated by officials’ inability to deal with the crisis, put those plans to rest.

This year I had expected Mr Tsipras to delay the elections until after the summer, so as to capture the tailwinds of yet another strong tourist season adding a further boost to growth. James Carville’s “it’s the economy, stupid”, coined for Bill Clinton’s 1992 US presidential campaign, could not be more relevant.

However, the EU election results in May, with ND at 33 per cent and Mr Tsipras’s leftwing Syriza at 24 per cent, tipped the balance towards an earlier poll. The margin between ND and Syriza has remained broadly unchanged for the past year, but Mr Tsipras had expected a narrowing following an increase in public-sector employment and some fiscal stimulus measures in the weeks before the EU election.

Those measures — tax breaks and bonuses for pensioners, in spite of austerity mandated by international bailouts — are not only characteristic of the pre-electioneering campaign, but also another sign of the shifting dynamics within the EU. In the next phase of the bloc’s development, power will be moving from the centre to the national governments, as already witnessed with Italy and France. Such moves are likely to be accelerated, as sociopolitical concerns prevent Brussels from exerting heavy influence, and as we get closer to the departure of German chancellor Angela Merkel.

This will obviously have significant and broader repercussions with some countries like those in the New Hanseatic League, a group of hawkish governments that takes a sceptical stance towards the vision of closer EU integration of French president, Emmanuel Macron.

Why should investors be optimistic? The existential issue of “Grexit” is behind us. The economy has stabilised and is growing, albeit close to 2 per cent given the constraints of a primary budget surplus, excluding debt servicing, of 3.5 per cent of annual economic output up to 2022.

Market sentiment has improved considerably as evidenced by recent successful bond issuance by the government. Ten-year bond yields are at all-time lows of 2.5 per cent and ASE, the local stock market index, is up more than 35 per cent this year. Furthermore, the manufacturing PMI numbers have been on an upward trajectory with the strongest levels for nearly 20 years, signalling a continuing improvement in the Greek manufacturing sector

Within services, tourism — which accounts for more than 20 per cent of gross domestic product — continues to flourish. This has been the key driver for international investors and private equity houses focusing on non-performing loan packages, along with assets in hospitality and real estate.

Yet, it could have been better if Greece were to be compared with Spain or Ireland. Foreign direct investment for 2018 may have surpassed €3.6bn, up 13 per cent year on year and three times higher than 2015, but high taxes, dense regulations and lack of structural reforms have held FDI back. Furthermore, non-performing loans still plague bank balance sheets, hindering them from helping the economy to grow.

Why should investors not be complacent? As with the experience of Gerhard Schroeder in Germany and Tony Blair in the UK, it tends to be easier for left-of-centre governments to pass through tough legislation. Likewise, Mr Tsipras has managed to pass tough measures with practically no social unrest for the past few years. This would not have been the case under any right-of-centre government.

Hence, investors should be cognisant that an ND government led by Mr Mitsotakis could reignite near-term volatility and social unrest. The Greek economy is not in the state of emergency it was after the eurozone crisis and hence the reforms will not be as punitive. But they will give the opportunity for grass roots supporters of Syriza, alongside trade unions, to create friction.

More importantly, it would place Mr Tsipras in the role where he excels the most — as leader of the opposition.

Is Mr Tsipras likely to win? If he had held off until September with the summer breeze to help him out, I believe he could. But now time is short and momentum is building for Mr Mitsotakis. Would a change in government necessarily derail the recovery? I do not think so, but the late summer meltemi will not be all smooth sailing. Ten-year bond yields, at 2.70 per cent, look expensive.

Your morning City briefing on companies in the news, job moves and what’s happening in the markets

Right now, it’s not such a good thing to be associated in investors’ minds with Neil Woodford. Since the star stockpicker gated his flagship fund — blocking investors from withdrawing any more funds — the spotlight has been on supposedly liquid funds with illiquid assets, a key problem for Mr Woodford. 

Last week, attention turned to the illiquid holdings of a different asset manager. FT Alphaville revealed London-based H2O Asset Management, which is owned by French Bank Natixis, had large holdings of illiquid bonds linked to a controversial German financier, Lars Windhorst (pictured). A day later, Morningstar, whose assessments are a key guide for investors, suspended its rating on one of H2O’s funds, citing concerns over the “liquidity of certain bonds”. H2O saw €1.4bn of outflows across six of its funds withdrawn between Tuesday and Thursday last week.

On Monday, H2O said it had sold part of its holding of non-rated private bonds and, based on a valuation from international banks, marked down the rest. The aggregate market value of the bonds now sits below 2 per cent of its assets under management. H2O laid the blame for the mark down on “press reports which dried up market liquidity and widened bid-ask spreads”. H2O’s funds will now be priced at a discount between 3 and 7 per cent.

The final line of a statement from H2O puts the focus on another thing Mr Woodford has found tricky: fees. H2O is waiving entry fees (though not types of fee) across all funds until further notice. Given Mr Woodford’s Equity Income Fund is suspended, it’s not like he needs to worry about charging investors to put money in. But while Hargreaves Lansdown has waived its own fees for clients invested in the fund, Mr Woodford’s refusal to drop management charges remains one of the key flash points for investors.

Natixis unit ‘marks down balance’ based on valuation from international banks

2O Asset Management has cut its exposure to what it calls “private bonds”, while marking down the valuation of its remaining holding, in an attempt to stem the investor outflows that have hit the €30bn bond fund manager.

The London-based subsidiary of Natixis saw €1.4bn of outflows across six of its funds, according to data up to Thursday, after the Financial Times revealed the scale of its holdings of illiquid bonds linked to a controversial German financier.

The fund manager, which has €30bn of assets under management, has been plunged into crisis after FT Alphaville reported that H2O’s latest filings collectively listed investments in more than €1.4bn of illiquid bonds linked to Lars Windhorst, a flamboyant entrepreneur with a history of legal troubles.

On Monday, H2O announced that it has sold a portion of its “non-rated private bonds” and “marked down the balance” based on a valuation from international banks. Natixis separately confirmed it was not one of these banks. H2O says its aggregate value is now below 2 per cent of its assets under management.

In efforts to stem investor outflows, H2O has also introduced “swing pricing”, where a fund provider prices their fund at a discount in order to pass trading fees on to clients that want their money back. The fund manager said these discounts would be between 3 and 7 per cent of the net asset value of their funds.

H2O also removed all entry fees across its funds, reversing a measure it took in December when it hiked “introduction fees” on five of its funds.

Natixis said in a statement that it supported the measures taken by H2O. In a move it said is aimed at “restoring confidence” in H2O, the French bank said it had brought forward a “periodic audit” of the firm, which it began on Friday.

Natixis’s share price fell 15 per cent over two days as concerns around H2O intensified, shaving close to €2bn off the bank’s market value. They were up 2.6 per cent in early Paris trading on Monday.

Morningstar, whose assessments are used as a key guide for investors, suspended its rating of an H2O fund the day after the FT’s report, citing liquidity concerns.

Asset managers claim they are not systemic but a larger scale fund run could show otherwise

“Absolute return doesn’t mean you’re up every day. It’s not possible.”

So said H2O Asset Management’s chief executive Bruno Crastes in an FT interview just four months ago. It proved a prescient comment. Last week, there were heavy withdrawals from several of its funds, after a series of articles in the Financial Times highlighted the firm’s exposure to highly illiquid bonds from companies connected to Lars Windhorst, the maverick German businessman with a history of legal troubles.

On Wednesday influential fund research group Morningstar withdrew its rating of H2O’s Allegro fund. By Thursday, the six funds the FT flagged as having exposure to Mr Windhorst’s businesses collectively saw more than €1.4bn of investor money withdrawn. Shares in H2O’s parent Natixis slumped 14 per cent.

Mr Crastes’ decision nine years ago to brand his firm H2O — because water is a pretty liquid substance and he boasted a decent record managing the liquidation of Amundi funds through the 2008 financial crisis — suddenly looks a little hubristic.

Earlier this month I wrote in this column that Neil Woodford was a canary in the coal mine. When instant-access investors in the star stockpicker’s Equity Income fund wanted to get their money out, Mr Woodford was forced to erect “gates” to prevent redemptions, due to large holdings of hard-to-sell unlisted stocks. Investors are still trapped in the fund and may be for a long time to come.

Now we have another canary.

While H2O has not put up the gates, insisting that “there is no question about the liquidity” of its funds, the cases have significant features in common.

Highly rated fund managers grow fast and invest in esoteric assets, designed to boost returns in an ultra-low interest rate environment. After a trigger, panic sets in about the quality of the fund manager’s underlying assets — small company equity holdings in Mr Woodford’s case; obscure bonds in H2O’s. Investors, who have instant access to their investments under Europe’s open-ended fund rules, rush for the exit.

Distrust is further stoked by apparent conflicts of interest. In Woodford’s case, the cosy relationship with fund distributor Hargreaves Lansdown has looked particularly ill-considered; at H2O Bruno Crastes sat on the advisory board of Mr Windhorst’s holding company, Tennor. (Mr Crastes stepped down on Friday, though only to be replaced by his chief investment officer.)

H2O’s problems appear less extreme than Woodford’s. It had up to €1.4bn invested in the controversial Windhorst-linked bonds — a significant amount. But relative to a €30bn portfolio, about 90 per cent of which is in liquid securities, such as government bonds, the danger does not yet look existential.

And on the conflict of interest point, Mr Crastes insists that the Tennor advisory board was set up at his insistence — with big names such as Standard Life Aberdeen’s Martin Gilbert brought on to it — precisely because the private companies needed close monitoring.

There will almost certainly be more trouble ahead, though. Even if investors’ distrust stabilises, there will be a further cycle of bad news. Official confirmation of investor withdrawals is likely to spook the market further. To keep regulators happy, H2O’s stock of illiquid bonds will no longer be valued on the basis of discounted cash flows but at market prices. In some cases, this may be closer to zero than face value.

Mr Crastes would argue that even a dramatic writedown of illiquid holdings would not hit the funds as hard as macroeconomic jolts: asset volatility is in the nature of an absolute return fund. And even if investors lose money, reversing years of outperformance, it is hardly of systemic concern if a €30bn H2O or a £10bn Woodford get into trouble.

Yet canaries they are, as was Swiss firm GAM last year amid its own liquidity crunch. Policymakers have begun warning that mass-appeal emerging market and high-yield bond funds may be the next victims of illiquidity.

The BlackRocks, Vanguards and Fidelitys of the world like to claim they are not systemic because they don’t carry the risk on their own balance sheets. Having trillions of dollars under management, including hundreds of billions across riskier asset classes, will feel pretty systemic to the world if the gas leak blows up the mine.