Weekly Digest

What lies beneath

Alex Harvey, CFA

17 June 2019

Hidden from view on the dark side of the moon, researchers last week discovered a vast unidentified mass hidden below the moon’s South Pole. A gravity map revealed an accumulation of material below the colossal 1,550-mile-wide Aitken basin impact crater, ever hidden from our view on earth by tidal locking. Just because we can’t see something though, it doesn’t mean we can ignore it. Part of our role as fund researchers is to look where the light doesn’t shine, as thorough due diligence may draw attention to red flags lurking in a fund’s shadows.

One of the most important attributes of any investment fund is the structure within which it sits and the mechanism by, and the frequency with which, its clients access their capital. In a nutshell, I’m talking about liquidity, which manifests itself largely in two ways: the awareness of capacity that sits alongside an investment strategy, and the suitability of underlying investments to a given fund’s structure. These are innately linked, yet subtly different, and whilst liquidity can be managed to capacity, it comes at the expense of the opportunity. The larger you get, the more market-like you become. The more market-like you are, the harder it is to outperform.

Clients and managers who know us will know the importance we place on capacity. It is important to ascertain early on the expected capacity of a strategy, and what factors might cause that to change. If the narrative for their capacity changes over time, then it could be cause for concern. As early adopters of a successful bond strategy in 2012, once the manager’s indicative capacity budget was blown we reviewed and ultimately sold out, well before its assets peaked at a multiple of the £1.5bn we noted in our early meetings. The fund remained liquid throughout but at the expense, we would say, of being able to generate meaningful alpha from bond selection.

In terms of asset suitability, at Momentum we are acutely aware of the potential liquidity mismatch between underlying investments and fund structures. For example, we do not advocate buying direct property through daily dealing funds. When did you last market, view and exchange on the same day? Let alone complete three days later? The seizing up of the daily dealing property market post the 2016 Brexit referendum attests to the problem, yet it persists. Closed ended investment funds with fixed pools of capital are a more suitable way for investors to access less-liquid markets. Liquidity risk is transferred to an exchange, but there is at least an observable market.

Recent events in the UK’s fund market highlight the issue. A flurry of redemption requests saw one of the UK’s most high-profile fund managers having to gate his flagship strategy. In this instance, (in)capacity and (un)suitability conspired together to lock down the fund. The market for stocks of which you are the majority owner is unlikely to accommodate you at your time of need. Pleasingly, our process identified the risks in 2016 and we promptly sold the holdings that were transferred to us via an acquisition from a third party. We raised similar concentration concerns in 2015 when reviewing an absolute return bond fund which subsequently fell to earth, having passed on the opportunity to invest.

Whether a celestial body or an investment fund, size does matter. Critical mass is needed to launch a strategy, but too much mass and you risk pulling others into your sphere of influence, distorting the natural market order. Any subsequent impact will be hard, the crater large and the outcome painful. Interestingly, we recently also learnt that water molecules have been detected at the Moon’s south pole. But in an illusion of liquidity, it happens to be ice.

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