The ethics of soft closure. Are emerging markets funds really closed?

The rout of emerging markets has exposed some serious ethical issues. As the crisis progresses, investors are still getting little more than soothing words from most managers. Much of this pays little heed to the change in outlook for the BRICs or the turmoil in emerging Europe. Few managers highlighted the risks in Ukraine, for example, which have sent the ruble to new lows. The idea that some emerging economies might sink back to uninvestable status has been conspicuously absent from manager reports.

And, is it right to maintain the fiction that some large funds are soft-closed, when in reality they are seeing outflows and still open for business? Investors are getting misleading information and signals from the investment professionals they trust.

The FCA has indicated a new focus on the behavioural aspects of client decisions, so should look at the guidance investors get. Maintaining the fiction that a fund is soft closed when it is in fact struggling to retain investors, falls far short of full disclosure. Soft closure itself is a blanket term, used as a catch-all for a mix of controls. It may not ban new money outright, but typically involves introducing new measures to make it more difficult or expensive to buy a fund.

Managers know that soft closure confers a cachet on a fund. Although designed to protect existing investors, any news of impending closure can encourage a stampede of investors rushing in before the door closes. It can look like a cynical ploy, exploiting a human fear of missing out. When a fund is actually seeing outflows, as with many emerging market funds in recent months, maintaining the ‘soft closed’ status seems designed to warn investors that if they sell they will be barred from later re-entry.

The offerings from emerging market gurus may not count as client advice, but they do increasingly penetrate social media and are given wide currency. All these signals do a disservice to clients, and fail to offer a rational analysis of what has changed. Public impressions of the industry are driven by the public evidence of the value it adds. Unblinking cheer-leaders for risky asset classes do little for public esteem. At a time when company guidance standards are being tightened to require a more balanced outlook statement, the fund management industry needs to raise its game.

Years of strong performance in emerging markets – as a wall of liquidity washed round the world – saw huge inflows into EM funds. This boosted currencies, and created bubbles in sectors such as emerging market property. The managers became stars and many funds grew so large they were soft-closed. For some funds this meant allowing continued access to some existing investors, but at premium fee levels. Somewhere along the way, the concept of treating customers fairly was lost. Or at least moved to a very technical interpretation, which satisfies compliance but does not impress the public.

The closures themselves seemed to spur demand, marking out the managers as so talented they could turn away business. Higher-charging feeder funds continued to suck in money, and the funds themselves became even more bloated. It would be a brave adviser who called the top on this, but it is the concentration of buy lists that has created the problem. Advisers, spurred on by regulation, have decided that herd-like behaviour – being in good company if something goes wrong – lowers their commercial risks. Advisers have applauded manager restraint on fund soft-closures, highlighting to clients how lucky they were to have got into these mega funds. There is a smugness about being inside a club with a strict doorman. Instead, investors should focus on how easy it might be to exit. In a panic the apparent liquidity of a large fund could be illusory.

Managers continue to market a long term growth story, with many clients mistaking the unintended consequences of Federal Reserve stimulation for real stockpicking skill. But, now that the tide of liquidity is ebbing, could the emerging market gurus be giving the wrong signals? There is a difference between the bias to optimism that pervades the financial sector, and abusing the trust of those who follow gurus blindly. Some of the emerging market stars have failed to offer any rational analysis of the changing profile of the emerging world. Investors may forget that, given the fees involved, these managers are hopelessly conflicted in assessing their own asset class.

And, after 19 weeks of net outflows, there is simply no new money to invest, no matter how cheap the managers say emerging markets now seem. Clients have suffered now 12 months of comforting words, typically suggesting the worst is past. Investment reports repeat the mantra of long term economic growth. Yet history shows little link between that growth and stockmarket performance.

Whilst long term records remain good – certainly for any manager that loaded up on beta in the boom years – 12 month figures in some big funds are poor. Perversely, the fund closures may actually have signalled a bubble in the asset class, or pointed to funds that took an aggressive stance in a bull market. The lack of flexibility to move money between markets was simply not recognised.

Regulatory pressures themselves have caused much of this problem, creating an unhealthy concentration of risk. But, if it ends in tears it will be fund management groups that are blamed. Investment professionals should recognise the need to maintain public trust, and avoid self-serving blind optimism. The industry must develop some standards to deliver best practice on fund soft closures.

A version of this article was published as an Op-Ed in Financial News on March 10 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image Doormen from Brian Geltner: license;

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