Review of property funds and liquidity risks

Our review into fund suspensions and pricing adjustments following the vote to leave the European Union shows that property funds should take external events into account as part of their planning in order to deal with potential liquidity risks. We are setting out our findings to help property funds respond to any future events which may impact on their liquidity.

The findings of our review will be considered alongside the responses to our Illiquid assets and open-ended investment funds discussion paper (DP 17/1)[2] which was open for comment until 8 May 2017.  The response to the Discussion Paper, including whether the current regulatory regime may need to be revised, will be summarised in a Feedback Statement in due course.

UK-domiciled open-ended authorised funds have approximately £35 billion invested in UK commercial real estate (as at the beginning of 2017).  Following the UK’s vote in June 2016 to leave the European Union, some daily-dealt property funds – and subsequently a number of unit-linked funds – had to suspend dealing in units and/ or apply pricing adjustments temporarily. This was because assets could not be realised quickly enough to meet redemption demand and due to the lack of certainty of property values.

We kept in close contact with all the authorised property funds and affected unit-linked providers during this period. Since then, we have looked at firms across the value chain, including depositaries, platform providers, wealth managers and financial advisers to see how they deal with liquidity risks.

The current regulatory regime goes some way to addressing the potential for unfair treatment of customers as a result of fund suspensions and pricing adjustments. However, we wanted to review how it had worked in practice in the period following the referendum, and whether there were lessons that we and firms across the value chain should learn, to help us to improve our response to any similar future market events.

What we found

Overall findings

We found that:

• The use of suspensions, deferrals and other liquidity management tools were effective in preventing market uncertainty from escalating further.
• The quality of liquidity monitoring and management varies between different property funds.
• The valuation of real estate assets poses challenges under stressed market conditions and firms need to consider how best to deal with this issue.
• Firms could be clearer in their communications, including to end-customers, following significant market events.

We recognise that the suspensions that followed the EU referendum raise broader questions about open-ended funds’ investments in illiquid assets, including whether the current regulatory regime may need to be revised.  We address these policy issues in our Discussion Paper (DP17/1), which was open for comment until 8 May 2017. 

Our approach

In our review we explored:

• Whether the firms had treated customers fairly when deciding to suspend funds and/or to apply fair value pricing (FVP) adjustments.
• The quality of communications both within the value chain and to end-customers, when trading in funds was suspended and when it resumed.
• The operational impact of the suspensions across the value chain.
• Whether the Authorised Fund Managers (AFMs) and Unit-Linked Providers (ULPs) undertook appropriate liquidity monitoring and management.
• Whether the AFMs had appropriate processes to price the property portfolios correctly.
• How the depositaries of authorised funds fulfilled their oversight role.

The review focused on:

• Daily dealt UK authorised property funds.
• Linked life assurance contracts, such as unit-linked life and pensions funds, where real estate assets were directly or indirectly used by the provider to back the value of the contract.

We engaged with over 60 firms to assess the impact of the fund suspensions and pricing adjustments across the value chain.

Findings in detail

By pooling contributions from investors, property funds play an important role in offering investors the ability to gain exposure to an asset class that might otherwise be too expensive, or simply impractical, for investors to invest in separately.

Open-ended daily-dealt funds that invest in illiquid assets will always, however, face the possibility that assets cannot be realised quickly enough to match the demand for redemptions from investors. Liquidity management tools, including suspension and deferred redemptions, can reduce the risk. Using these tools after the referendum helped to avoid market uncertainty escalating, and our detailed findings should be seen in this light. In using such tools, property fund managers need to ensure their investors understand the implications for their ability to redeem.

For some firms within the value chain, as well as the end-customers, applying FVP adjustments raised as many issues as the suspension of the funds; this is reflected in our conclusions. 

Key findings by sector

Authorised Fund Managers (AFMs)

In general, AFMs did not adequately plan, or have clear policies and procedures, for valuing their property portfolios under stressed market conditions.

Some AFMs did not adequately consider the implications of their distribution model in their liquidity monitoring and management of funds.

AFMs could improve their communications to platform providers, to enable platforms to communicate more effectively in turn with advisers and end-customers.

Unit-linked providers (ULPs)

Some ULPs did not appear to understand fully the underlying portfolio of open-ended funds they were investing in.  We found some examples of poor governance over the unit-linked product range, such as senior management lacking awareness and understanding of unit-linked mirror funds.

Unit-linked funds holding real estate directly did not appear to manage their liquidity well.

ULPs took different approaches to informing customers of deferrals and their impact on regular contributions and contractual withdrawals.  Some issued no communications at all.

Depositaries

Depositaries appeared to provide an effective, independent check of AFMs’ adherence to Collective Investment Schemes (COLL) sourcebook under normal market conditions, but they did not appear to have considered fully how they should fulfil their responsibilities under stressed market conditions.

Platform providers

In general, platforms relied on manual override solutions to process the fund suspensions and would be unlikely to have the operational capability to deal with simultaneous, or a higher volume of, suspensions.

Some platforms cancelled standing instructions for regular payments and withdrawals relating to the suspended funds and required investors to resubmit instructions once the funds resumed trading.  In our view, instructions should be suspended only temporarily, until normal conditions resume.

Wealth managers and financial advisers

Wealth managers and financial advisers were well prepared for the suspensions. Given the diversified nature of their portfolios, the suspensions had little impact on clients.  Firms and their clients appeared to have more concerns about the application of FVP adjustments than about the suspensions.

Not all firms had considered the implications of the suspensions for their model portfolios (e.g. the scope for divergence from the target asset allocation).

Wealth managers and financial advisers generally appear to remain committed to including daily-dealt property funds in client portfolios, as a way of helping to achieve a diversified asset allocation.

Next steps

We expect all firms that were affected by either the suspension of property funds or the application of FVP adjustments will – if they have not already done so - review how they dealt with this event. This should include examining relevant policies and procedures and considering whether there are any improvements that could be made that would enable them to deal more effectively with a similar market event.

We are providing feedback to all firms that have participated in our review.  In some cases, individual firms will have to implement remediation measures to ensure they comply with our expectations and requirements.

The findings of our review will be considered alongside the responses to our Discussion paper.