The GFC reminds us that a product’s structure is critically important – even more than its potential return, says David Wright
The severity of the global financial crisis (GFC) and the impact it has had on financial markets and investor returns has brought a strong focus on virtually all financial services participants and their practices. One of the areas that has impacted on a large number of investors – through fund closures, redemption freezes or “liquidity gates” – is product structure. That is, the freezing of mortgage funds, direct property funds and “fund-of-funds” hedge funds – or funds-of-hedge funds (FOHFs) for short – has led many to question the validity of the product structure of these investments. Is this a fair assessment and will product structures evolve as a result of these issues? ARE CURRENT STRUCTURES FLAWED?
In relation to the freezing of redemptions from mortgage funds and direct property funds, the main issue has been the lack of liquidity of the underlying assets at a time when investors wanted their money back. To put it bluntly, these product structures allowed and facilitated daily applications to, and redemptions from, funds with underlying assets that could not, in practice, be bought and sold on a daily basis. This was fine when fund inflows were strong and any investor that wanted their money back could be easily funded out of the fund’s cash reserves, fund inflows or the orderly sale or maturing of assets within the fund’s investment portfolios. However, when investor panic set in and investors wanted their money back and new fund inflows dried up, the underlying assets could not be liquidated to meet the flood of redemptions.
In many ways this is the old trap of attempting to match long-term assets (mortgages, property) with short-term liabilities (investor funds). Interestingly, this is not a new issue and in many ways is a repeat of the property and mortgage fund collapses of the late 80s and early 90s. However, to be fair, this time around the redemption run on mortgage funds was exacerbated by the Government’s bank deposit guarantee, which led to many investors seeking to switch their money from non-government guaranteed mortgage funds in favour of government-guaranteed bank deposits.
INTRIGUING FEATURE
The other intriguing feature of mortgage funds is the fixed unit price (usually $1.00 per unit), which gives the impression that the value of the underlying mortgages does not change and that the asset class is capital stable. This is clearly not correct as the true value of mortgages changes with changes in official interest rates and bond yields, just as the value of other fixed-interest securities moves to reflect the prevailing interest-rate and yield environment. This is particularly true for fixed-rate mortgages. As an example, a fixed-rate mortgage issued three years ago at 8.5 per cent is obviously more attractive to investors than a fixed-rate mortgage now at 5.5 per cent. In other fixed-interest-based funds the value of the assets adjusts to reflect this, which in turn is reflected in the unit price – but this is not so for mortgage funds.
Similarly, the issue for direct property funds was also the lack of liquidity of the underlying assets of the funds when investors wanted their money back. Of all the asset classes, direct property funds are one of the more predictable from a capital value perspective. The rolling nature of revaluations of the underlying properties makes it easier to anticipate the direction (if not the magnitude) of a fund’s unit price. That is, because direct properties are re-valued infrequently (on an annual basis at best), it is relatively easy to anticipate a decline in the unit price of a direct property fund when the underlying assets come up for revaluation if you have already observed significant downward pressure on property values. When the more astute investors and/or advisers anticipated the latest devaluation, this added to the flood of redemption requests to direct property funds.
UNDERLYING ILLIQUIDITY
The freezing of redemptions in FOHFs is also largely related to their underlying illiquidity; however, this illiquidity is driven more by the fund structure rather than the illiquidity of the underlying investments. While it is true that the underlying assets of some specialist hedge fund managers are illiquid, a large percentage of FOHF portfolios are invested in hedge fund managers whose underlying assets are highly liquid (for example, long/short equity managers). The illiquidity is therefore driven more by the structure of the hedge fund industry and the subsequent impact this has on the legal structure of the fund.
To explain, the structure of a FOHF is not like a global equity, global fixed-interest or global REIT fund where the underlying assets are held directly by the Australian registered fund. Most, if not all, FOHFs that are accessible by Australian retail investors have a “feeder fund” structure where the Australian registered fund “feeds” into or invests in an overseas registered fund that in turn invests in the underlying funds of the selected hedge fund managers. This means that when Australian investors redeem their investment from a FOHF, the FOHF has to sell units in the overseas fund, which in turn has to sell its investment in the underlying hedge fund managers. As many of the underlying hedge fund managers have fixed lock-in periods or liquidity “gates”, where they provide limited redemption from their fund on a periodic basis, this is what causes the illiquidity of FOHF investments.
ONLY FOR THE LONG TERM
What should have been obvious prior to the GFC should be very obvious now – that each of these asset classes is illiquid and therefore should only ever have been used for investors with long-term investment horizons who did not require immediate liquidity. This raises a couple of pertinent issues for the industry. The first is that, in some cases, these products have been “sold” incorrectly, resulting in investors being placed in these products when they should not have been. The second is that the extensive use of portfolio administration platforms (wrap accounts and master funds) and the demand from advisers, researchers and investors to use these products within portfolios has resulted in managers providing product structures that are platform “friendly”, offering daily application and redemption. This is the prime reason we have seen the development of open-ended, unitised, direct property funds in recent years.
PRODUCT STRUCTURES – WHERE TO FROM HERE?
So after all that has happened, what’s the future for these types of funds and/or their likely structure going forward? For both mortgage funds and direct property, Zenith believes the most likely scenario is “back to the future”. That is, both of these forms of funds may actually adopt features that were used previously. For mortgage funds, the re-introduction of exit fees for the first three years of an investment in the fund may be one way of discouraging short-term investments into the funds. As an example, managers could apply a 3 per cent exit fee for investors redeeming in the first year of their investment, 2 per cent for redemptions in the second year and 1 per cent in the third year, which is a structure that was common when retail funds were popular, prior to platforms and wholesale funds dominating. This is a structure that seemed to work quite well in encouraging a medium- to long-term investment in mortgage funds. The major issue with this structure is whether the administration platforms can (or are prepared to) administer this type of structure.
For direct property, it’s likely we’ll see fixed-term, closed-end, property syndicate structures emerge once again, albeit with lower levels of gearing than before. This structure tends to be more transparent and yield-driven than the open- ended, unitised direct property funds that have evolved over recent years; and investors enter the fund knowing they are locked in for the term of the investment. Again, the main issue with this structure is to ensure it is effectively administered by the administration platforms. The opportunistic nature of syndicate offers – where they are open for a short period of time, until all of the required capital is raised – is also problematic for advisers using model portfolios, as the property exposure within the portfolio relies on the ability to continually find new syndicate offerings within the model portfolios for new clients.
FUNDAMENTAL CHANGES
The solution for FOHFs is more problematic as it requires a fundamental change in the structure and practices of the hedge fund industry, which is unlikely to happen quickly. Even prior to the GFC, some managers used structured approaches such as notes or swaps in order to facilitate daily liquidity for their FOHF. Neither of these structures has been well supported by advisers and investors, due largely to the added complexity they bring to the fund and the difficulty in explaining these structures to clients. Given the “back to basics” approach of many advisers in product selection and portfolio construction and avoidance of structured, non-transparent features post-GFC, there is a very low likelihood of the structured approach being the accepted solution any time soon.
In conclusion, while some product structures will almost certainly change and evolve as a result of the issues highlighted by the GFC, history repeats itself in terms of many of the lessons learnt. That is, avoid investing in illiquid, long-term assets if ready access to cash is required – no matter how attractive the return.
