I’m sure by now you will have read all there is to read about Neil Woodford’s suspension of redemptions for his equity income fund and the knock-on effects it has had on investors, clients and platforms. It highlights a few things that normally cannot be found on the usual research engines but which can be, and have been, critical in the decision to invest in a fund at or close to its launch phase.
I’m sure when researching potentially exciting new funds you always obtain a copy of the prospectus and read it. I have found them to be quite impenetrable. One reason is that it will tell you lots of things you need to know and to bear in mind when considering selecting any fund, but the way it is written, often full of legalese, can make it hard to understand. One other point worth noting is that the investment remit set out in that document is often deliberately broadly written so that it gives the fund manager the widest choice of investments in any future circumstance.
But there is much more information that we need to find out. Let’s go back to first principles. If you want to launch a fund, how would you do it? What do you need? What are the costs of launch and what are the ongoing running costs going to be? To whom will it be marketed? What will be the investment strategy? Will it gear (remember that even open-ended funds can borrow some money for short terms)? What are those terms and circumstances where that might happen?
I have found prospectuses to be quite impenetrable
Launch costs can be substantial, running into hundreds of thousands of pounds. There are the usual costs of registering, research, team/administration amongst other things, and then add the marketing on top. Most of those costs are borne by the fund itself, although some might be borne by the management company running the fund. So how much of these costs will be borne by the fund itself at launch? These questions apply to all funds, open or closed-ended, with liquid or illiquid assets.
Next, we need to find out who the other investors are. There are potential extra risks here: the number of institutional investors and private investors. Remember that to secure enough capital to launch a new fund the management company will normally need some sizeable institutional investors to invest at the start. Over time we normally see the concentration of ownership of funds dissipate as more private investors buy in and existing investors exit. Some institutional investors are other investment funds who have a wide spread of private investors holding the shares, but some are bigger corporate entities, local councils or pension funds.
Another question – what has to happen to the shareholder makeup for there to be a run on the fund? Let’s think it through … if the investor base is heavily weighted towards a small number of large investors, it might not take many of them to liquidate their holdings for a liquidity issue to arise, as redemptions need to be met from the sale of assets. If this happens, you tend to sell the most liquid holdings first, which means you are then left with the less liquid holdings with wider spreads and a different portfolio to when you invested. If there is a number of smaller investors, then there are many more people in the mix making those decisions to invest or not. The more people making decisions, the less likely that they will all reach the same decision as each will be driven by different motivations.
Morningstar is often a good place to find out details of the largest shareholders in any fund you might be researching. There are always lots of factors to consider when researching funds, but the events of early June offer a timely reminder that when looking at relatively new funds, we go the extra mile and broaden the research process compared to those which already have been running some years and have a wide shareholder base.
This article was originally published in Professional Paraplanner. Republished with permission.