The unintended lifetime commitment

By Dan Hallett, CFA, CFP on March 29th, 2012

When entering a marriage, it’s a bad sign if you start planning your exit before vows are ever exchanged.  While many of life’s lessons extend to the world of investing, the exit strategy is a notable exception.  Unlike in marriage, investors should spend more time contemplating their exit strategy to help avoid the unexpected liquidity trap.

Labour sponsored funds

A lucky contingent of labour sponsored investment fund (LSIF) investors bought in the mid-1990s.  They were lucky because when the mandatory holding period expired, LSIFs’ strong performance allowed them to sell at a healthy profit.  But LSIF investors that jumped in after the winter of 1997 drew the short straws.

With a longer holding period that ended in a bad environment for LSIFs, many later investors either lost money or became locked-in well past the minimum eight-year holding period.  Many investors still hold LSIF shares that should have ‘expired’ years ago; forcing some to hold on for a dozen years and counting.

Frozen LSIFs include the former VenGrowth funds acquired by Covington last year and GrowthWorks Canadian fund.  (This list would be lengthy if including those funds that were amalgamated or folded.)

Other specialty funds

Hedge funds can sometimes be difficult to exit.  Initially there may be a ‘lock-up’ period – i.e. where you can’t sell for a year or two after the initial investment.  Subsequently, quarterly redemptions are common, with 30-120 days of advance notice.  But like LSIFs, hedge funds often have clauses allowing them to freeze redemptions – i.e. a “gate” – when doing otherwise is deemed harmful to remaining fund investors.  While this is normally associated with hedge funds, virtually all funds have gates.

A prime example is the class of open-ended real estate mutual and segregated funds (unlike private real estate investment trusts and limited partnerships) given that they ‘house’ very illiquid assets inside of a very liquid mutual fund structure.  A liquidity crunch hit real estate funds in the early-to-mid 1990s and again a couple of years ago.  When a stampede of investors tries to sell their units at once, sponsors will freeze redemptions to control liquidity.

While investors have fallen into liquidity traps in specialty investment funds in the past, some investors are finding themselves stuck in more traditional funds.

Closed-end funds

Traditional closed-end funds function like mutual funds but trade like stocks.  Unlike an exchange-traded fund (ETF), sellers of closed-end funds must find a sufficient supply of buyers to exit.  This is why most publicly-traded closed-end funds trade at a price below the value of its underlying investments.  Of the 157 closed-end funds for which lists discount and premium data, 115 recently traded at a discount to their net asset values.

There are many examples of mainstream closed-end funds with thin trading volume.  Urbana Corp for instance had recent trading volume equal to $5,800 per day.  Trident Performance Corp II recently traded an average of less than $9,000 daily, which is fine for small investors but very illiquid for larger sums.  These and many others can go days and weeks with little or no trading, making it difficult at times to get out of these funds.

Two closed-end funds offered by ABC Funds – North American Deep Value and Dirt-Cheap Stock Fund – are unique funds in which some investors feel stuck today.  These don’t trade on a public exchange so ABC Funds maintains an internal “virtual exchange” whereby it matches hopeful sellers with willing buyers.

In recent weeks, ABC’s website said that roughly 90 investors were looking to sell out of each of the firm’s closed-end funds.  But not one investor was ready to pony up the $50,000 minimum needed to buy existing investors’ units – and hasn’t for some time.  ABC has facilitated some modest selling but a line-up of eager buyers is needed to ease the long list of those waiting to exit the funds.

Since these funds were launched when their manager – Irwin Michael – was on a relative performance high, most probably never thought a time would come when nobody wanted to invest in the funds.  I find it hard to believe myself but suspect that patient investors will be rewarded in time.  However, those wanting to liquidate are stuck for now and may be in an unintended lifetime commitment.

The next potential liquidity trap

The aforementioned list of past liquidity traps can help to uncover the next one.  While the above list of investments couldn’t be more different from each other, they share two important commonalities.  First, while the specific factors driving their popularity varied, there were specific periods in time when each of the aforementioned investments were very popular.

Second, investors appear to have downplayed the liquidity risk of each.  For example, it’s common knowledge that property can’t be quickly or easily liquidated.  So allowing investors to frequently buy and sell property funds only works while the investment is in favour.  And I suspect that investors never imagined such an imbalanced supply-demand ratio.

So the next liquidity trap is likely to be a popular class of investments today that hold very illiquid investments.

Accordingly, private mortgage funds could be the next liquidity trap but not until their popularity abates.  These intriguing funds are gaining in popularity thanks to juicy yields and claims of rock-solid unit prices.  While our firm is starting to examine these funds – and there are lots of them – here is some food for thought.

Many such funds claim that unit prices (or capital value) are constant – a suspicious claim on the surface.  Funds that invest in bond-like investments are short-changing either buyers or sellers by not adjusting unit prices to reflect changes in interest rates (and credit spreads).

More generally, you don’t get an 8% yield in a 2% interest rate environment without taking significant risk.  Risks include credit risk, interest rate risk and liquidity risk.  Don’t underestimate any one of those (or other) risk factors, particularly liquidity.  Case in point:  ROI Capital recently froze redemptions on four private placement pools that generally bear some similarities to private mortgage funds.

According to this press release, ROI froze redemptions after one large source of inflows dried up.  ROI claims that there are no defaults or other big negative events affecting any of the funds’ investments.  But you hit a bottleneck when you have much more money wanting to leave than you have coming into a fund that invests in illiquid assets.

Prior to investing, evaluate risks under less favourable scenarios by asking pointed questions.  What is the impact of rising interest rates on the market value?  What happens when many want to sell but nobody wants to buy?  How much might I lose when loan defaults hit 5 or 10 percent?  Asking and getting answers to these and other questions just might help you avoid an unintended marriage to your next investment.