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The importance of liquidity when investing in capital markets

Hard on the heels of the ill-fated UK equity mutual fund managed by Neil Woodford, a real estate fund from the giant UK fund group MG has also faced problems as investors rushed for the exit fearing to redeem shares. Last week, fund managers at Standard Life Aberdeen were also under pressure to provide cash when investors withdrew 1.3 billion from the fund, an amount equivalent to six months of redemptions.

Neil Woodford was once a celebrity star investment fund manager, but his flagship UK equity fund was suspended when he was unable to sell underlying securities to raise cash to meet investors' requests to redeem shares. Woodford's fund had a large exposure to small private companies, and these companies proved difficult to liquidate.

The MG investment group's real estate fund also recently had difficulty selling underlying assets in order to realise cash to cover investor redemptions, because investors holding UK real estate investments were nervous in the run-up to the UK general election.

When managing money, the ability to generate cash with readily saleable assets is important, especially if the fund or construction allows for daily redemptions.

All these funds were open-ended, meaning that investors are able to receive a share price and redeem shares.

However, the manager can only return cash to meet redemptions of shares if there is a market to sell underlying assets. Real estate is notoriously illiquid, which is why banks are reluctant to hold real estate on their balance sheets for very long.

Investors wishing to invest in real estate in the capital markets should consider investing in a closed end fund. Whilst the investor is unable to redeem shares, he avoids the risk of the manager mismanaging liquidity and the fund being suspended.

Because the capital markets are a reflection of human behaviour and endeavour, the two most important subjects to be considered in investing are market cycles and risk.

As Mark Twain is thought to have said, "History doesn't repeat itself, but it often rhymes."

Market history is replete with examples of investments that failed investors when they were unable to withdraw capital. When liquidity is mismanaged and investors are unable to redeem shares, the least able to lose capital usually end up the most disadvantaged.

When investing in capital markets, investors should think very carefully and be wary of open-ended funds that invest in illiquid assets like real estate and small private companies.

The author is a member of the Society of Trustees and Estate Practitioners and an investment counsellor. jb@ehh.gi

The comments and observations by the author are a reflection of his opinion and do not constitute an offer to buy and hold securities, nor does he receive any remuneration of any kind from names referred to.