Dash for trash: How a European funds rule can hurt investors
‘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.