Investing in a Fund? Check your exits

Some funds carry serious liquidity risks. If you’re caught in the wrong one you could lose a lot. How can you tell if you are?

When conceiving and creating our new funds, I obsessively asked one question: What could kill them? Because it’s an obvious — but frequently overlooked — fact that survival is a necessary ingredient of success.

Fund liquidity is one such killer. So I’m hot on it.

You’d love my single, catch-all rule here, right? Sadly in fund investing, as in life, things are more complex — so there’s no silver bullet.

But if you want a simple pointer; imagine being in a theatre.

OK. Now imagine a fire breaking out in that theatre.

Why? Because funds’ liquidity-risk controls are often as useless as box-tick corporate health & safety assessments: They’re carried out in times of calm, when what really matters is what happens in a panic.

There are plenty of variables in that theatre. But for our metaphor, there are a few that really matter: How big is it? How many exits? Are those exits clear or blocked? How big are they? How big are you? How many people are in the theatre with you? And how big are they?

Take one scenario: What if a fire breaks out in a small theatre? How likely are you to survive?

Hard to say, right? Because you don’t know the other details.

If it’s just you and one other punter in there (perhaps it’s an impenetrable Danish play about the deeper meaning of consciousness), then, even if there’s only a couple of exits, you’ll be able to mosey out with no problem (provided you haven’t nodded off — a genuine risk in that scenario).

Likewise, if the theatre is small but this time it’s full (Strictly’s in town!), you could still be OK, as long as the theatre has plenty of exits. Much then depends on whether you get trampled by a large, panicking man who’s steamrolling his way to safety.

Clearly we could talk burning theatre scenarios all day. But we should get back to funds.

The UK’s biggest liquidity blow-up of recent years was Woodford. The key facts were that his was a large, popular fund that held some deeply illiquid positions (they were unlisted stocks, so to sell them he needed to find another specific buyer, he couldn’t just send them off to the market). The fund was also held by many holders who didn’t understand fund investing, some of which were huge (Redactedshire County Council Pension Scheme — take a bow).

In the Woodford case, the risks were so high that it didn’t even take a fire in the theatre. It was more like an usher had a cheeky smoke in the loo, and some of the holders caught a whiff and got worried about a fire.

So they left.

Which caused more to leave. Which, eventually, spooked Redactedshire County Council into making a mad dash for the fire exit. But, on account of its generous girth, it got itself jammed — trapping everyone behind it.

This is the exact opposite to the funds I hold: I prefer small, unpopular funds that hold liquid securities. This is equivalent to a modest theatre that’s nowhere near full, and has lots of big, clear exits.

To be clear on the above, the funds I pick are not so much “unpopular” as “not-yet-popular”. I believe my edge is finding newer funds that will perform so well that, in the future, they will become popular. Then, should I judge they’ve become too popular, I will calmly collect my coat and head for the exit.

I also take time to understand who’s in there with me. If there are outsized co-investors, I want to know who they are, and how jumpy too. But often, because I swim with the minnows, my funds of funds are the biggest holder. This suits me just fine.

This contrasts with the assumption made by many fund holders, which is that large funds are automatically safer. But they’re not. In all sorts of ways they’re riskier than their smaller counterparts, and it’s as well to know this.

But size alone isn’t the answer. It’s crucial to consider all the relevant factors, acknowledging there isn’t one that’s key by itself: It’s how two or three might combine that creates the risks.

These include: The size of the fund and its realistic capacity; the liquidity of the investments it holds (small; mid-caps; large caps? Listed or unlisted?); how many positions it holds; how big a stake it has in those securities; and who else invests in the fund, and how much of it they own.

Check these factors in your funds (and your theatres), and you can sit back knowing your exits are clear. If you don’t? You could get burned.